A number of first-time home buyers and borrowers of modest means opt for Federal Housing Administration 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. But you'll need to review your untaxed income and benefits to make sure you'll not only qualify, but will also be able to afford your new house payment.
Basics of Gross and Untaxed Income
Lenders consider debt-to-income 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. It's important to get your debt as low as possible before you start the homebuying process since you may not be in control of upping your income significantly during that time. But there are other factors that will be figured, including your FHA gross up income.
Determining Gross Income
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 7 of IRS's new Form 1040. The Department of Housing and Urban Development, 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 benefits income, 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.
Examples of Untaxed Income
Some gross income that is used for FHA qualifying is untaxed. Examples of untaxed income include 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 FHA gross up income. For FHA gross up income, the lender adds back a percentage based on the tax rate you used to calculate your previous year's income tax. The lender uses the higher, grossed-up amount of your untaxed income and benefits to figure out DTI ratios.
Once you have followed the examples of untaxed income and added it to your other income, you'll need to calculate your debt-to-income ratio. 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. But even if you pass the lender's qualifications, it's always important to take a look at your untaxed income and benefits to ensure you can comfortably afford the new house.
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