One of the major changes in lending guidelines made nearly 10 years ago was making sure mortgage lenders verified income. Up until around 2008-2009, the proliferation of so-called “stated” and “no doc” loans made getting a loan approval almost a no-brainer. Such loans also contributed to the housing crisis as those who wouldn’t normally be able to be approved for a loan due to credit or income could easily find a lender who would issue an approval. Such easy money fired up an over-heated housing market and someone could buy a home and immediately flip it and make a profit. Thankfully those days are long gone. Today, lenders are required to document an “Ability to Repay,” or “ATR”, for most every loan program available. This means documenting income.
When someone fills out a loan application there is a section for household income. Income documentation comes in the form of several ways. The first is to collect copies of recent paycheck stubs covering a 30 day period. A pay stub will show gross pay, net pay and year-to-date income. This income is also verified by viewing copies of the last two years of W2 statements. Bank statements are also used to help verify income. If someone gets paid on the 1st and 15th of every month, a bank statement should show regular deposits appearing on those dates. For someone that is self-employed, the most recent two years of tax returns are reviewed along with a year-to-date profit and loss statement. Again, bank statements are used to back up reported income. Now enter the 4506-T form.
The IRS 4506-T form is an authorization for an entity to retrieve federal income tax transcripts directly from the IRS. Even though income is verified through various third party documents, tax transcripts will still be ordered. It’s not an option but a requirement for most programs. The lender will compare the income stated on the application and verified via paystubs and tax returns. The 4506-T will show what the IRS has on file. With tax filing software and online applications, it can be relatively easy to complete and print out modified tax returns. It’s because of these apps and the lender’s obligation to thoroughly document income that lenders ask the 4506-T to be signed. The “T” by the way stands for transcripts.
So, what happens if the income on the application and the retrieved transcripts are different? That’s where an explanation comes into play. The lender will want to know why there is a discrepancy and in most instances the application won’t go any further. If a lender can’t comply with the ATR requirements. If a lender approves a loan and does not comply when the loan guidelines ask for it, the loan will not be eligible for sale in the secondary market and must remain on the lender’s books. Mortgage companies aren’t set up to keep loans on the books and collect the monthly payments. Without the ability to sell a loan, it eats into the lender’s credit line and reduces its ability to approve another loans.
It used to be that the 4506-T was required only for self-employed borrowers, but changes made most all applicants sign the form. Verifying and validating income is one of the reasons default rates and foreclosures have fallen significantly over the years, as credit and the ability to repay have been reviewed and approved.