Declining Income: Mortgage Underwriting
When reviewing a file, there are occasions where a borrower has declining income. While declining income is not ideal, it may not represent an insurmountable problem during the loan approval process.
There are two primary questions when determining the qualifying income of a borrower with declining income. First, has the decline stopped or reversed? Second, what was the reason for the decline? If it can be documented that the income is no longer declining, that is a major factor. For the second, prudent underwriting requires to know the reason and if it is likely to be reoccurring or is it a “one off” event.
Regarding the first question, if the borrower is employed as a salary or hourly borrower, a letter from the employer may suffice. If the employer is able to adequately document why the decline has occurred and the factors that resulted in the decline have ended, the loan application may be acceptable. If the borrower is self-employed, this question is more complicated and will be discussed below.
As to the second question, sometimes the decline in income can be the result of an unusual event. We have seen such an event recently with the COVID 19 pandemic. An unplanned and truly “one off” event. Our contract underwriting and contract processing areas are seeing many borrowers who have had a dramatic drop in income and now a return to more normal levels of pay. Other examples of unusual events may include a company losing a major customer, a temporary plant closure etc. Every file is different and must be judged on its own merits.
Self-employed borrowers present a special challenge when it comes to declining income. Due to the very nature of self-employment, there will be year to year fluctuations in income. What happens when the borrower shows two years of return and there is a decline from the earlier year to the most recent?
The first step is to complete a self-employed income analysis and determine the percentage of decline. While not written in guidance, a good rule of thumb states declines of <10% from one year to the next may not represent an unacceptable risk. A simple letter of explanation from the borrower may be enough to overcome the risk of the declining income. As a reminder, in no instances can a higher number from a prior year be “averaged in” for a higher qualifying income.
But what to do when there is a large decline in income from one year to the next? Is this a dead deal? Again, not necessarily. At the Commonwealth Group, our experienced contract underwriting and contract processing teams may ask for another year of prior tax returns to determine if the prior year of the two was simply a great year. For example, look at this income pattern:
· 2019 = $100,000;
· 2020 = $175,000;
· 2021 = $103,000.
In this case. 2020 was a strong year for the borrower and the borrower should not be penalized because of it and 2021 reflected a more normal income. The qualifying income used for this example would be $103,000.
While a short blog post cannot address every situation, declining income may not always be an instant denial. Working with an experienced contract underwriting or contract processing team is key. For more information on understanding credit reports, contact [email protected] for assistance. For current contract underwriting and contract processing customers of The Commonwealth Group, please use the Scenario Desk email for specific questions.
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