Effective Income: What Is It?

If you are looking to purchase a home and aren’t 100% sure you are going to qualify for a mortgage due to your income, then it is in your best interest to know what Effective Income is and how to calculate it.  If we are looking at FHA Loans, you are going to want to get the income requirements straight from the FHA HUD Handbook 4000.1.  These are the requirements set forth in September 2015 release of the Single Family Housing Policy Handbook.

According to and within the context of FHA Loans, Effective Income is any income that can be used to qualify a borrower for a home loan.  HUD guidelines also state that the borrower’s Effective Income should be reasonably likely to continue through the first three years of the mortgage.  In addition to this FHA borrower’s must also meet certain criteria which we will go over in the coming paragraphs.  In understanding this, you are going to be able to determine your Effective Income and see if you will qualify to use all your income or just a portion of it.

Effective Income: General Requirements

When you are working to obtain a mortgage it is a standard requirement for the borrower’s income to be verified as well as their employment history in order to get them qualified.  In a practical sense, Effective Income is to be considered as income that is legally obtained and also reported and recorded on the borrower’s income tax returns.

In most cases Effective Income is also expected to be recorded via a W-2 form and at the same employer for the past 2 years.  In the event that a borrower has not been at the same job for at least 2 years consistently they are going to be required to facilitate evidence in one of these forms: W-2s, Verification of Employemnt (VOE), Electronic Verification that is acceptable and permitted by FHA, or Evidence supporting enrollment in school or the military during the previous 2 years.  When it gets closer to closing your loan there is a re-verification of the borrower’s employment that is going to take place and will be finished about 10 days prior to the date of note.  According to the 4000.1 Handbook, a “Verbal re-verification of employment is acceptable.”

When calculating Effective Income there is alternative documentation of the borrower’s current employment that can be used.  If your lender is using alternative documentation you will need to obtain your most recent pay stubs with year-to-date earnings, obtain your original W-2 forms from the previous two years, and document current employment by telephone, and notate who you spoke with and get a signed verification document.

Effective Income: Additional Required Analysis of Stability of Employment Income with Frequent Changes in Employment

If the borrower has changed employers more than three times in the previous 12-month period, or has changed lines of work, the lender must take additional steps to verify and document the stability of the Borrower’s Employment Income. Additional analysis is not required for fields of employment that regularly require a Borrower to work for various employers (such as Temp Companies or Union Trades). The lender must obtain:

• Transcripts of training and education demonstrating qualification for a new position; or
•  Employment documentation evidencing continual increases in income and/or benefits.

Effective Income: Addressing Gaps in Employment

For borrowers with gaps in employment of six months or more (an extended absence), the lender may consider the borrower’s current income as Effective Income if it can verify and document that:

• the borrower has been employed in the current job for at least six months at the time of case number assignment; and
• two-year work history prior to the absence from employment using standard or alternative employment verification.

Effective Income: Calculating Income (Salary versus Hourly)

When you are looking at Effective Income and trying to properly calculate what the effective income truly is you need to know the difference between Salary and Hourly earnings.  Salary is for employees whose income is fixed and they receive a certain amount on every paycheck that is not driven by the hours worked.  For salaried borrowers, their current salary would be their Effective Income.

When looking at hourly employees it is required that when calculating Effective Income that the applications current hourly salary is what is used.  If an employee has a job where hours vary, you would take the average of income earned over the last 2 years.  If the borrower can document an increase in pay rate then the most recent 12-month average of hours will be used at the current pay rate.

Effective Income: Conclusion

As you can see, calculating Effective Income when looking to get a mortgage can be complicated especially when dealing with gaps in employment and hourly employees.  Knowing this, it is vital you work with someone who is a professional at this and can determine exactly what can be used and how much.

If you have any questions, you need to call me ASAP at 888-900-1020 or visit my website for even more information or to start an application at www.loanconsultants.org.  I look forward to working with you in the future!