Qualifying Income for a Mortgage: Expert Advice and Considerations

It should come as no surprise that mortgage lenders have a somewhat different view of income that can be used to qualify for a mortgage. While they will generally accept the income sources that you have or might expect, how they calculate it – and what specific documentation they will be looking for – will vary based on the source, length, and amount of the income.

You should be prepared for lender requirements in regard to your specific income sources before applying for a mortgage.

The General Rule: Qualifying Income Must Be “Stable”

Mortgage lenders generally look for three primary factors when considering your income for qualification purposes:

1. Consistency of the income received,
2. How long it has been received, and
3. The likelihood that the income will continue in the future.

Naturally, those considerations are more easily addressed with certain income types than with others. Let’s take a look at how mortgage lenders look at the various sources of income that are typically used to qualify for a loan.

Employment Income

This is the income you receive by salary or wages when you are employed by someone else. Lenders will usually substantiate this by a combination of recent pay stubs, W-2s, and either verbal or written verification of your employment from your employer. In addition to income numbers, they will also be looking to verify your job title, your length of employment, and the likelihood that your employment will continue.

If you are a salaried employee, they will generally accept that salary as your income for qualification purposes. If you are an hourly employee, they may average your income over the past year or two.

Many employees also receive additional income, such as overtime, bonuses, or commissions. In such cases, that income will typically be averaged over the past two years. If it is substantial, which is defined as representing 25% or more of your total income, they may also request signed, completed tax returns.

They will also generally look for a two-year employment history, though they will accept less if you are new to the workforce.

Self-Employment Income

Mortgage lenders generally require that you have been self-employed for a minimum of two years. They will verify this with copies of income tax returns for the past two years, and often require a copy of a business license, or verification of the length of self-employment with your CPA, or some other service professional.

Your income will be averaged over the most recent two years – which is to say that they will not accept your best year as your income for qualification purposes. Certain adjustments will be made in the income calculation, such as adding back depreciation expense, since it is not an actual cash expense.

The lender will be looking for a pattern of either stable or increasing earnings. If your net income from the business (they don’t ever use gross sales) is $75,000 in Year 1, and only $50,000 in Year 2, they will qualify you based on the lower income. However, if your loan is otherwise considered to be high risk, they may decline your application for unstable (declining) income.

In addition, the lender will almost certainly have you complete IRS Form 4506, which is a request for your tax transcripts. That information will be used to verify that the income tax returns you have submitted to the lender are valid with the IRS. (Hint: really bad things can happen if they’re not!)

Rental Income

Once again, lenders will be looking for a two-year history of the rental income that you want to qualify with. Naturally, this will represent net income, which is gross rents, less the expenses (including financing) of owning the property. As is the case with self-employment, they will add back non-cash expenses, such as depreciation.

If the rental income is from investment properties, the lender will require the two most recent years tax returns, complete with Schedule E, income from rental property. In some situations, they may also request copies of recent leases.

Just as is the case with self-employment, lenders will use the net income that you receive from rental properties, and add it to your other income. However, if there is a loss on your rental properties, the shortfall will be calculated on a monthly basis, and added to your long-term debt, in order to calculate your debt ratios.

If the rental income being used to qualify is from the property that you are purchasing, the lender will rely on market rent information provided by the property appraisal. The projected rent income, less estimated rental expenses, will be added to your income for qualification purposes.

Investment Income

Investment income can get a little bit quirky. Mortgage lenders typically require the following in order to consider investment income for qualification purposes:

1. A minimum two-year track record of receiving investment income, but they will sometimes require you to demonstrate at least three years, and
2. An investment asset base sufficient to support the investment income claimed.
3. In virtually any situation where you need investment income to qualify for a mortgage, you must willingly be prepared to provide income tax returns for the past two or three years, as well as financial statements proving the value of your investments.The lender will generally average interest and dividend income over the past two years. But if you’re using capital gains income, they will average it over three years. They will also look for consistency of the income. In the case of capital gains, if you have one big year, and two losing years, they probably will not accept the income.

Retirement Income

Social Security and pensions are fully acceptable sources of qualifying income. You typically need to document them only with a copy of an award letter, or either a recent pay stub or an annual 1099-R statement from either the pension administrator or the Social Security Administration.

Income distributions from self-directed retirement accounts, such as IRAs and 401(k)s, will generally need to be supported by tax returns, in much the same way that you prove investment income. This is because such plans typically do not involve formal distribution systems, but are instead accessed at the owner’s leisure.

However if you’re over the age of 70 1/2, when your retirement accounts are subject to required minimum distributions (RMDs) the lender is likely to accept a broker’s statement detailing the amount of the RMD. This will be acceptable, since RMDs are consistent from year-to-year, and are required by the IRS once you attain that age.

Secondary Income Sources

This represents a collection of income sources, but the two most common are part-time jobs and side businesses.

For part-time jobs, the lender will generally look for a two-year history in which you held both your full-time position and your second job. Because of the nature of the part-time arrangement, they will likely average your income over the past two years, which will be supported by a recent pay stub and W-2s.

For a side business, consideration will be very similar to what it is for full-time self-employment. The lender wants to know that you have maintained a side business, and that it is profitable, for at least the past two years. You will be required to provide two years tax returns, complete with Schedule C, verifying your income.

While lenders will look for a two-year history with either a part-time job or a side business, there may still be value in the income source if you’ve had it for less time.

If you have either source for less than two years, but more than one year, the lender may accept the income as a compensating factor. That means that while they won’t use the income for qualification purposes, they will recognize it to “shore up” your loan application.

The extra income source can be seen as a counterbalance to less-than-perfect credit, a high debt ratio, or a low down payment.

If you’re applying for a mortgage, volunteer any income sources that you have. The lender will let you know if it is an acceptable source for qualification, and then walk you through the steps of verifying the income. Even if they don’t use it to qualify you, it can still help your application.