Part 1: Ability to Repay, Components of Income.
Think back to the last time someone asked to borrow money from you. Chances are you gave them an answer in a few seconds. Your brain quickly calculated the risk by factoring in the dollar amount, your knowledge of their financial situation and your relationship with them. You essentially determined (what the mortgage industry calls) the ability-to-repay.
Ability-to-repay (ATR) is nothing new but has surfaced in recent mortgage regulation. A large part of ATR involves analyzing income which seems simple enough by reviewing documents such as a W2 or pay stub. Income, however, is much more dynamic.
- Base Pay vs Other Income
If I asked how much you make you'd probably give me an hourly or salary figure. But odds are you make more because you worked over-time last summer and earned that Christmas bonus. Or perhaps you work for commission, in which case, you might give me the year-to-date figure on your recent pay stub. Regardless of the different types, lenders separate income into two categories: base pay and other.
Base pay is your hourly or salary rate and, according to underwriters, is considered stable since there is a reasonable expectation it will continue so long as you’re employed. Other income types, such as overtime, bonus, or commission are heavily influenced by outside factors such as workload or performance and are considered less stable.
- Debt-to-Income Ratio
You can make all the income in the world yet spend it all monthly and have nothing. Sounds like a proverb but what I mean to say is that income isn't the only metric in ability-to-repay.
Income is measured against your outstanding liabilities, those that appear on your credit report. The calculation creates a ratio which is known as debt-to-income (DTI). Since it's unreasonable to verify and document, to the fullest, a borrower's financial situation, we follow generic thresholds which have developed through years of lending. These new ability-to-repay regulations have created a standard debt-to-income guideline of 43%, a rule most lenders will likely adhere to.
Are you wishing you had known this before you lent money to your brother? Or perhaps you think lenders are going extreme by drawing a box around your multifaceted financial profile? As we progress with this series, we will explore how underwriters view the various 'other' types of income and how you might utilize them to your advantage.