A number of first-time home buyers and borrowers of modest means opt for Federal Housing Administration (FHA) loans because of the flexible qualifying guidelines. Borrowers with no rental history, credit challenges and low incomes are good candidates for FHA loans. FHA loans feature government insurance protection, which makes it possible for lenders to finance otherwise risky borrowers. The FHA lender reviews your income and verifies its source to determine the maximum loan amount you can afford.
Lenders consider debt-to-income (DTI) ratios to calculate how much of a payment you can afford. There are two types of DTI ratios. The housing ratio, known as the front-end ratio, compares your monthly housing payment to your gross income; the back-end ratio compares your total recurring monthly debt to your income. DTIs are expressed as a percentage. The FHA prefers that your housing payment remain within 31 percent of your income and that your total monthly debt remain within 43 percent.
The lender considers your gross income -- the amount you make before taxes or deductions -- when calculating your DTI ratios. It uses the adjusted gross income indicated on line 37 of IRS Form 1040. The Department of Housing and Urban Development (HUD), which sets FHA guidelines, defines gross income as the annual amount earned by the borrowers who will be responsible for the loan. Wages, social security payments, retirement benefits, military and veteran's disability payments, unemployment benefits, welfare benefits, and interest and dividend payments are considered gross income for FHA qualifying, according to the HUD.
Some gross income that is used for FHA qualifying is untaxed, including certain disability and public assistance benefits, military allowances and child support. The lender may add back a portion of the untaxed income to your gross income. This method of calculating income is known as "grossing-up." The lender adds back a percentage based on the tax rate you used to calculate your previous year's income tax, or 25 percent. For example, the lender may gross up child support income by multiplying the amount by 125 percent. It uses the higher, grossed-up amount to figure out DTI ratios.
To consider your income in the DTI calculation, the income must be considered "effective," that is, continuous for at least the first three years of the mortgage. Effective income is verifiable and stable. The FHA lender verifies its likelihood to continue with your employer via an employment verification letter or phone call. The lender reviews your income tax returns, usually for the past two years, and recent pay stubs to determine your income stability. Lenders verify non-employment-related income with award letters, by referring to federal tax returns or by contacting the source of its payments. For example, a former employer would verify a pension.
- HUD: Handbook 4155.1: Chapter 4, Section D: Stability of Income (p. 4-D-2)
- HUD: Handbook 4155.1: Chapter 4, Section F: Qualifying Ratios (4-F-4)
- HUD: Handbook 4155.1: Chapter 1 Section B: Required Documents for Mortgage Credit Analysis (1-B-15)
- HUD: Handbook 4115.1: Chapter 4, Section D: Salary, Wage and Other Forms of Income (pg. 4-D-9)
- HUD: Handbook 4155.1: Chapter 4 Section D: Income Analysis: Individual Tax Returns (IRS Form 1040) (pg. 4-D-19)
- IRS: Form 1040
- HUD User: Glossary of HUD Terms: Gross Annual Income
- HUD: Handbook 4155.1: Chapter 4, Section E: Non-Taxable and Projected Income (p. 4-E-15)
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