SANTA CRUZ (March 21, 2009) - When it comes to qualifying steadily employed, salaried employees for a new loan, the mortgage industry simply uses the borrowers’ current gross income. If the borrower just got a raise, we count the new income. If the borrower chooses to have a large chunk of income devoted to a 401(k) or an IRA, we still use the gross income before deductions. It is this gross income that we use to calculate the all-important Debt-To-Income (DTI) ratio. Loans are approved with DTI ratios up to 65 percent (for loan amounts above $417,000 that maximum DTI ratio is 50 percent)!.That is, under ideal circumstances a borrower may spend up to 65 percent of his or her gross income on all of their long term debts. These include their monthly Principal, Interest, Taxes and Insurance, car payment,  monthly credit card payments, child support, etc.

On the other hand, income for those who derive all or a part of it from self employment often feel unfairly treated when it comes to obtaining a mortgage. It is the ‘Net Profit’ that is reported on their federal tax returns that is used in the DTI ratio calculation. To top it off, the mortgage industry will usually require a borrower to have been self employed for at least one to two years and will use the most recent two year average of their net profit as reported on their two most recent federal tax returns. This is assuming that the borrowers’ income is increasing. If it is decreasing, an underwriter may use the lower income and will want an explanation as to why income is falling.

This time of year, before federal tax returns are due for 2008, a lender may accept the 2006 & 2007 tax returns for a self employed borrower; however, we have seen in some situations that underwriters are requiring the 2008 tax returns before the loan is given a final approval. This may be especially prevalent with loan amounts over $417,000 and/or when income has been derived by real estate or stock investments (both of which have suffered appreciable losses in 2008).

There are a couple of entries that self employed borrowers may take advantage of on their tax returns. One is depreciation. Since that is considered a ‘paper loss’, it may be added to the net profit when calculating the income that will be used for mortgage qualification purposes. Also, some underwriters allow borrowers to add back in their home office deductions.

Some borrowers have chosen to incorporate their business and do not consider themselves self employed. If a  borrower has incorporated, he or she most likely receives a salary and year-end W-2s. The rule is that if the borrower owes more than 25 percent of the business, the underwriter will also want to review two years of corporate or partnership returns.

We had a situation recently in which the borrower owned 100 percent of his corporation and had paid himself $100,000 on his W-2 for the year but a review of his corporate returns showed a $100,000 corporate loss for the year. More than likely, this self employed borrower made little or no income that year.

Calculating income to determine whether or not a borrower will qualify for a new loan can be a complex process. Even employees who work for someone else may have to average their bonuses, overtime or commissions received in order to come up with the income that a lender will accept for mortgage purposes.

Note to my readers: I write about situations and events in the mortgage industry that come up every day in my business; however, I am always looking for new topics of common interest. Please feel free to write or call with your requests.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 of email him at Peter@SantaCruzHomeFinance.com.