There is an ‘Ability to Repay’ or ‘ART’ rule that lenders follow when approving a traditional mortgage. When lenders calculate income, they are required to both determine and document that determination of whether or not someone can safely afford a new home loan. This is a result of the vast mortgage guideline changes implemented in 2008-2009, one of several. Prior to this introduction, there were certain loan programs that did not make this determination. Instead, the introduction of so-called “stated income” or “no-doc loans” became more and more prevalent. With these loans, a stated income loan program meant the lender had no responsibility to verify the borrowers could afford the new mortgage but instead used whatever income they entered on their loan application.
It got to the point that some very unscrupulous loan officers would tell the applicants how much they needed to put on the application in order to qualify. You can guess the result. Further, a “no-doc loan” needed no documentation. No paycheck stubs, no W2s, no tax returns….it was a disaster. Fortunately the loan officers and the lenders that made sure these types of loans are no longer around.
The Ability To Repay (ART) Rule Explained
The result is the ATR rule. Lenders were required to verify affordability by comparing the new mortgage payment which included not just the principal and interest payment but also a monthly amount for property taxes, insurance and mortgage insurance when needed. Income was verified by collected the most recent month’s worth of paycheck stubs, W2s and income tax returns. Comparing the new monthly mortgage payment along with other monthly credit obligations and dividing that amount with gross monthly income resulted in a ratio, referred to as a debt ratio. These ratios can vary but most like to see the house payment be somewhere around one-third of gross income.
How Lenders Calculate Monthly Income
Calculating monthly income is fairly easy by collecting paychecks from the 1st and 15th or whenever they got paid that month. But the math works a little differently when someone doesn’t get paid on a monthly basis. Many employees get paid every week, for example. Someone could receive a weekly paycheck every Friday. But some months have more than one Friday, right? Initially one would assume there are four weeks in every month, hence four Fridays. But that’s not always the case. A month could have five Fridays. Getting paid every other week also presents a similar situation. Most times getting paid every other week can mean every other paycheck results in a monthly amount. Again however, sometimes there are more ‘every other week’ paychecks in one month and not just four. How do lenders calculate this income when there is no regular monthly paycheck?
Why Calculating Bi-weekly and Weekly Income is Different
Let’s look at those who get paid weekly. Let’s say someone gets a paycheck every Friday in the amount of $1,000. Most months, the gross monthly income is 4 X $1,000, or $4,000. Easy-peasy. But what about those other months when the ‘extra’ paycheck messes with the math? Here’s how getting paid weekly is calculated. The lender takes the $1,000 and multiplies it by 52 (weeks). Using this example, multiplying $1,000 by 52 is $52,000. Again, easy. But we need a monthly amount in order to allow lenders to calculate monthly income and figure debt ratios. $52,000 divided by 12 (months) will provide the qualifying number. The qualifying income in this scenario is then $4,300 per month, not $4,000.
A similar calculation is used when employees get paid every other week. Again, using an amount of $2,000 every other week, the qualifying income isn’t $4,000. Instead, $2,000 is multiplied by 26 (weeks). The result is again $52,000. Dividing $52,000 by 12 (months) the answer is the same…$4,300.
This can be a concern when potential borrowers who get paid weekly or bi-weekly to prequalify themselves using the smaller amount. You might easily see how someone who gets paid every other Friday to arrive at a $4,000 monthly income, shortchanging themselves and thinking they can afford a lower loan amount by using the smaller number.
This just one more reason why potential borrowers shouldn’t ‘fly solo’ without a loan officer. If you or someone you needs gets paid in this manner and are thinking of applying for a mortgage, call me to make sure that person qualifies for the amount they’re entitled do.