Have you ever applied for a mortgage and wondered why your lender asked for your tax returns for the previous two years?
Debt-To-Income Ratio
One of the main qualifying factors used to approve a mortgage is your debt-to-income ratio (DTI). This number is calculat- ed by dividing all of your debt by your income.
Your DTI helps the lender determine if you can afford the new loan, per their guidelines. And it gives the lender an idea of how much money you have left over after your minimum bills have been paid.
Lenders first determine your monthly debt by pulling your credit report and adding the payments on all open debt. Then, they determine your income. If you are a salaried or hourly employee, your income is calculated using the last 30 days of pay stubs and your last two W-2 statements.
So Why Tax Returns?
Lenders also ask for your tax returns (1040) because unlike paystubs and W-2s, tax returns help to explain the entire story about your income.
The lender needs to know if you are writing anything off. Tax write-offs may pose a problem with your mortgage applica- tion. The general rule is that if you are not paying taxes on it, the lender is not going to allow you to use it as income.
Losses, Unreimbursed Expenses, and Depreciation
The most common tax write-offs are unreimbursed business expenses, Schedule C losses, and Schedule E losses.
Unreimbursed business expenses are shown on Line 21 of the Schedule A, and can include mileage, uniforms, dry cleaning, cell phone bills, industry publications/journals, job trainings, etc.
If you have a self-employment business you might file a Schedule C or a Schedule E depending on how you structure the business. A Schedule E may also be filed if you own rental property or receive royalties. Both Schedule C and Schedule E may show losses.
Anything listed on line 21 of the Schedule A and any losses from Schedules C or E may be netted out of your income.
On your Schedule C, however, any depreciation that you claim may be added back into your income. The same applies if you file S-Corp returns for your Schedule E self-employment business. Any depreciation filed on those returns may also be added back in to your income.
More to the Story
The story of your tax returns does not end there, however. Your tax returns will also tell the lender if your home has any farm income, if you pay alimony, or if you have received unemployment income.
If you file a Schedule F (farm income) on the property you are refinancing, it may make you ineligible for certain mortgage programs.
If your tax returns list alimony paid to an ex-spouse, that alimony payment may need to be listed as a liability when calculating your debt to income ratio. This can affect your approval.
Your returns will also show if you have received any unemployment compensation, which might require a letter of explanation about your employment history. This can also affect your approval.
Your tax returns play an integral role in the qualification process of your mortgage. If you have any questions or concerns about whether or not you will qualify, a Meridian Home Mortgage Loan Officer is available to answer your questions. Please do not hesitate to contact us.
