Calculating Borrower Income: Rules Every Underwriter Should Know

Calculating borrower income is one of the most significant and detailed steps in the underwriting process. It ensures that the lenders get a clear picture of a borrower’s true financial strength. This helps them make safe, well-informed lending decisions.

It is important that underwriters adhere to strict guidelines when calculating borrower income. This helps them understand loan qualification with clarity based on a realistic assessment of financial capacity and risk. How do they go about this? The important things to follow involve verifying stable and consistent income sources. They must also accurately account for all debt obligations using specific debt-to-income ratio formulas. Mortgage underwriting guidelines help lenders decide whether a borrower has the financial stability to qualify for a home loan.

This article explains the key methods underwriters follow to calculate borrower income across different income types accurately.

It is typically understood that there are various income types like fixed, variable, and self-employment income, alongside many others. While calculating income for mortgage underwriting, we consider the different types of income as follows:

• Salaried and Fixed/Consistent Income: For borrowers with a fixed salary, income calculation is upfront. 
• Variable Income like commission and bonuses: Variable income is calculated by averaging over a period to determine a stable monthly amount. This is usually two years but may vary.
• Self-Employment Income: These include business owners and independent contractors. Such incomes require a more in-depth analysis of their finances. 
• Non-taxable Income: If someone has a verified income source that is non-taxable, the lender can "gross up" the income for calculation purposes. 

Now, it is very important to know the difference between gross and net income. 

Gross income  is the total amount one earns in a year before any other expenses are considered. It’s the total revenue your job generates. This can be from providing services or product selling. This is the amount before taxes, deductions, or other costs. 

To calculate the gross income, businesspeople can sum up all the money earned from their clients over the past year. If a client pays you $100,000, that’s your annual gross income. 

The gross income is very important as it showcases a business’s revenue potential. Thus, you can analyze who is paying you more and which projects are generating more income, thereby aiding your growth. 

Now, let us come to net income. Net income  is the profit earned after subtracting all business expenses and any deductions from a person’s gross income. 

To calculate the net income,  one must begin with their gross income. Subtract all expenses like marketing and taxes. It also includes deductions like retirement contributions or professional fees. 

Suppose your gross income is $100,000 and your expenses total $25,000; your net income is $75,000.

Variable income refers to the income that is not derived from a fixed salary. Such an income can change based on factors like how much sales you make, any temporary project-based work, or the company performance. Variable income is not only about  commissions, bonuses, and overtime, it also includes self-employment income, besides interest, dividends, or any other non-fixed income that must be averaged over time.

The variable income of an individual or business tends to fluctuate over time. It can be monthly or yearly fluctuations. Therefore, lenders must  perform in-depth analyses of its stability and continuity.

Underwriters usually consider calculating borrower income based on a history of receipt, comprehensive documentation, and an income trend analysis. It is recommended typically that the calculation is based on a minimum of two years of receiving variable income. The income must definitely continue. If a downward trend is noticed, underwriters use the most recent or lowest average income rather than averaging over an entire period.

Underwriters assess a borrower's qualifying income by verifying documented, stable sources. They are then compared against monthly debt obligations to determine a debt-to-income (DTI) ratio.

The borrower income verification involves reviewing documents like pay stubs, W-2s for salaried employees, and tax returns for the self-employed. The DTI calculation includes all recurring monthly debts divided by gross monthly income.

According to the underwriter income rules, a borrower's debts and obligations primarily impact qualifying income by determining the Debt-to-Income (DTI) ratio, a critical metric for assessing repayment ability. The total of all recurring monthly debt payments is subtracted or calculated as a percentage of the gross monthly income to determine how much income is left for a new loan obligation.

Normally, underwriters review a borrower’s debts and financial obligations. This helps them understand the exact income of the borrower after their commitments.

DTI Ratio Calculation:

Underwriters use the DTI ratio to see how much of a borrower’s income goes towards debt each month.

Formula = (Total Monthly Debt Payments / Gross Monthly Income) × 100%

Other important calculations include:

Front-End and Back-End Ratios:

The front-end ratio looks only at housing costs like mortgage, taxes, insurance, etc.
The back-end ratio looks at the housing costs plus other monthly debt payments.

Typical DTI Limits:

Many lenders prefer borrowers to stay around 36% or lower.

Some government-backed loans, like FHA, may go up to 50% depending on the borrower’s overall profile.

One must remember that everyday living expenses like groceries, phone bills, and insurance are usually not counted in the DTI ratio.

When one evaluates income for self-employed borrowers, there are some special considerations that should be taken into account because their earnings can fluctuate every month. To solve this issue, underwriters typically review at least two years of tax returns, and their financial statements to understand the borrower’s income. Because self-employed income is less predictable, these borrowers must have the necessary documentation so that they can prove that they meet loan obligations.

Tax documents play a major role in income calculations as lenders use taxable income and not the gross revenue. Deductions such as depreciation and business expenses can significantly change the income reported on a tax return. It is important to know which tax items should be included as it helps find the final income calculation. This must reflect the borrower’s real financial capacity.

Accurately calculating borrower income is essential to responsible lending, whether the borrower is salaried, self-employed, or has multiple income streams. By carefully reviewing documentation, understanding tax impacts, and applying consistent rules, underwriters can form a clear picture of the borrower’s financial stability. This ensures fair, safe, and well-informed lending decisions that protect both the borrower and the lender.