Underwriting: Aspects of Income

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By Anne Elliott

Conventional methods for deriving qualifying income work most but not all the time. With special circumstances, thought is involved.

Declining income

Declining income doesn’t have to be a deal breaker. The following are several rationales for loan approval:

  • Debt ratios so low that even additional decline does not jeopardize affordability. A letter of explanation addressing the potential of stabilization is advised.
  • Additional sources of income making the declining income less relevant.
  • Significant equity combined with abundant reserves supporting the borrower’s motivation and ability to repay.
  • A rebounding economy. At the end of an economic downtrend, businesses (unless affected by other factors) are apt to trend upward.
  • A well-qualified co-borrower, occupying or otherwise.
  • Decline so minimal it is irrelevant.

The transaction type is relevant when there is declining income. A rate and term refinance with a slightly lower payment and/or a longer term, particularly when the new loan term is considerably longer than the current loan’s remaining term, evidences desperation and may be too risky for prime financing. A rate and term refinance with a shorter term may offset concern with hardship. A cash-out refinance is suspect. Loan proceeds could be targeted for propping up a business, starting up a replacement business, or providing the down payment on a less costly home. The purchase of a second home or investment property could be a move-down or a buy and bail, depending on equity in the primary residence.

If the borrower’s CPA is willing to address the reason for declining income and potential for turn-around, this may be helpful in decisioning. Not all CPAs are involved in the operations of the business; their expertise may be restricted to income tax filing. However, a hands-on CPA can provide an impartial opinion or increase concern if that statement appears to be hedged.

Sympathy for the borrower is poor rationale for loan approval.

Fluctuating income

Fluctuating income should be distinguished from declining income. It occurs in various lines of work. Examples are attorneys who handle major cases, developers with longer-term projects, and those in the entertainment industry. Options for supporting documentation are a chronological project list, a written explanation from the CPA, and/or additional tax returns. Signed contracts for upcoming projects can also support the pattern.

The most justifiable method of handling fluctuating income is documenting a recurring pattern, e.g., alternating higher- and lower-earning years or two lower years followed by a higher year, and then averaging appropriately.

Projected income

Traditional examples of projected income were a beginning stockbroker with no history of commissioned earnings or an employee with less than a two-year history of performance-based bonus income. Projected income has since expanded to a newly-hired academic before the school year begins or a recent retiree beginning to receive pension and social security benefits.

The traditional examples remain unacceptable. The expanded examples demonstrate the limitations of the one-size-fits-all philosophy. Projected income can now encompass a spectrum ranging from speculative to assured. To qualify the newly hired academic, a signed employment contract should be adequate even if a verbal VOE or pay-stub is not available prior to closing. Educators legitimately prefer to relocate before the academic year begins. To qualify the new retiree, award letters or the equivalent are needed. For both examples, the dollar amount of qualifying income is not speculative.

The greater risk for academics is not in the initial months of teaching but several years after if tenure is not granted. The greater risk for newly retired borrowers is inability to adjust to reduced income, more so if savings do not bridge the gap. If the industry is willing to accept the greater risks, it should reconsider the expanded definition of projected income.

 

Anne Elliott

Anne Elliott studied mortgage risk throughout her professional career. Her upcoming book, Underwriting with Thought, or An Alternative Approach to Responsible Origination, will be published in early 2017.
Contact her at anne@digitology.com

 

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