6-15-18: We have plenty of money in our accounts and a ton of equity, why is my income so important?
Question of the week: We have plenty of money in our accounts and a ton of equity, why is my income so important?
Answer: Because it is not 2007 anymore and in 2010 the Dodd-Frank Act was passed by Congress and signed into law.
Some history. After the mortgage and housing market melt downs Congress behaved as politicians usually behave, they felt the need to “do something” as a reaction. The “something” was the Dodd-Frank Act which ran 2300 pages with the intention of reforming the American financial system and preventing future market collapses.
One of the many facets of the Act was mortgage reform that required any lender that wanted to avoid risk retention rules to follow the guidelines set forth by six different government agencies for underwriting what are termed Qualified Residential Mortgages, or QRM’s. If a lender wants to have more leeway in its underwriting guidelines it can choose to not follow the QRM guidelines but must retain at least 5% of the mortgages it funds and then securitizes—i.e. they have some “skin in the game.”
All conventional, FHA and VA mortgages are underwritten to the QRM standards, as are most Jumbo loans and the vast majority funded by individual banks and lending institutions. Those loan that are not QRM qualified are typically have higher rates and often are some type of hybrid ARM (fixed for 3, 5, 7 years then rate is adjustable).
The primary principle of the Qualified Residential Mortgage guidelines is Ability to Repay. Lenders funding a QRM mortgage must document the borrower’s ability to repay the mortgage under the terms of the note on a consistent and regular basis. In layman’s terms, you have to show proof of income that will support the monthly mortgage payment of principal and interest on the loan.
Income is defined as money received on a constant and consistent basis as demonstrated almost always on tax returns (some exemptions may be regular distributions from a Roth IRA or annuity, or starting in 2019 for divorce agreements made prior to December 31, 2018 alimony received).
What is not income?
The equity in your home is an asset, not income. If you have a home worth $600,000 and owe $200,000 you have $400,000 in equity and a loan to value of only 33%. That is great, but it does not help qualify your mortgage as a QRM for the lender.
The funds in your investment account are an asset, not income.* + If you have an account with a brokerage that has $500,000 invested in various mutual funds, stocks, bonds and some cash, for most mortgage products the account balance is not able to provide assistance for the income needed for mortgage qualifying. That said, one of the factors for qualifying income is constant and consistent. Presumably the account generates interest, dividend and some capital gains income that you report on your tax returns. If you can prove the constant and continuing nature of the income (i.e. two years tax returns showing you paid taxes on interest, dividend and capital gains income) that income can be used for qualifying.
*If you have investment accounts that are retirement accounts, 401k, IRA’s, etc and you are over 59 ½ and eligible to take withdrawals without penalty and a regular payment from the account(s) has been established that payment can be used for qualifying income.
+Some loans will allow “asset depletion” guidelines on very large accounts where by a formula is used to convert the asset account to income. Not every loan program allows the asset depletion and those that due make it a bit challenging for most to have it qualify for income.
Here is an example that seems contrary to common sense (not uncommon it seems in our industry).
Couple have a home worth $2,000,000 and owe $300,000 on their current mortgage. They wish to remodel the home and to do so want to obtain a new mortgage in the amount of $800,000. After the loan funds they will have a loan that is only 40% of the value of the property.
The couple have an investment account with $1.2 million invested in various funds. The funds were mostly inherited in 2017 so they only have one year with substantial income reported on their tax returns from interest, dividends and capital gains.
Both couples work and have annual income of about $130,000 per year with two car payments and small credit card balances.
Can they qualify for the $800,000 refinance mortgage? With many lenders the answer is no, they will not qualify based on the lack of history of receiving income from their investment account. Some lenders may qualify them using asset depletion, but since the money was inherited and it was recently most lenders’ guidelines would not allow the asset depletion guideline until there is more seasoning on the funds.
With 60% equity in the property and one and a half times the amount of the applied for mortgage available in somewhat liquid assets common sense indicates the couple will make payments on the mortgage. But as we have seen only a decade ago, if the economy turns very sour, their housing value drops as does the balance in their investment account and they struggle to make the payment on the home with their salaries will they continue to make payments? Will they take what may be left in their investment account and pay it off or dip further into it to make payments?
Lenders are not in business because they make loans based on if the borrower does not make payments they can foreclose, sell the home and get their money back. That is a losing business premise due to the very high costs to foreclose and unknown future market conditions. If this was the case most loans would be what they were before the creation of the Federal Housing Administration as part of Roosevelt’s Alphabet Agencies created during the New Deal—50% down, short term mortgages.
This couple can get a loan, but it could well be a non-QRM product that will have a higher interest rate and possibly not a 30 year fixed rate.
When a future market downturn occurs, and it will, there will be significantly fewer foreclosures, which will dampen the impact of the market downturn, in large part because of the Qualified Residential Mortgage guidelines requiring the overwhelming majority of mortgages on homes across the nation have borrowers who were able to prove they have the income to support their mortgage payments.
It is great to have money in the bank and investment plus a lot of equity, but when it comes to qualifying for a mortgage those factors are not as important as your qualifying income.
Have a question? Ask me!
A lot of data this week on the economy. Prices continue to increase with the Consumer Price Index in May up 0.2% for the month and 2.2% from last May. Wholesale prices also rose, up 0.3% for the month and 2.4% year over year. The steady price increases are positive for the economy and consumer prices are over the Fed target of 2.% inflation, overall the news is somewhat unfriendly for mortgage rates. Also unfriendly is the unemployment claims data which shows the four week moving average of continuing claims at their lowest since December 1973—that is an amazing statistic given the size and breadth of the labor markets today compared to 45 years ago. Throwing more pressure on rates was a very positive month for retails sales which were 0.8% higher in May than April, despite being held back by slower auto sales.
The Federal Reserve Open Market Committee had a surprise. On Tuesday the FOMC announced a 0.25% increase in its discount rate, that was no surprise as the stated intention from the Fed last year was for three rate increases this year, and this was long slated to be the second increase. What was a surprise was the report that accompanied the rate announcement. One surprise was an omission from prior reports, taken out of the statement was that rates will remain low for some time. The other surprise was the Fed indicating there will more than likely be two more rate increases this year instead of one. With the announcements the immediate impact is on homeowners with Home Equity Lines of Credit as your underlying rate, the prime rate, increased this week to 5%, the announcement of two more increases indicates the prime rate will likely be 5.5% by New Year’s Day 2019 and likely 6.25-6.5% by 2020.
Rates for Friday June 15, 2018: There is a lot of conflicting factors impacting interest rates. Positive economic news at home putting upward pressure on rates, economic and financial challenges in Europe putting downward pressure, international trade conflicts over tariffs putting downward pressure on rates and investors trying to figure this all out have reacted by moving money back and forth between stocks and bonds. The result for the mortgage applicant is a steady week for conforming rates and a bit of a bump for high-balance rates from last week. The mortgage market remains somewhat unstable and the advice is not to try to guess when rates will drop but to lock in your rate when you are able.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:
30 year conforming 4.375% Flat
30 year high-balance conforming 4.75% Up 0.125%
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
What a week being the parent of high school kids. Those who read last week’s very brief WR&MU know I was in Boston with the oldest going through orientation—it was a very good but tiring trip (starting off on a red-eye has that impact on me). Getting a chance to take a tour of Fenway Park and then to see a game there with a buddy of mine from high school was one of the highlights. Then we came home to family in town for the Baccalaureate at Poly High School on Sunday followed by graduation on Wednesday. Phew, time for a little down time—perhaps a weekend watching the U.S. Open will restore my energy….
Happy Father’s Day to all the dads out there!
Have a great week,
Dennis
