What do mortgage lenders look for on your tax returns?

Published April 22, 2020
by Better

When you apply for a mortgage, your lender is likely to ask you to provide financial documentation, which may include 1 to 2 years’ worth of tax returns. You’re probably wondering exactly how those tax returns can affect your mortgage application. We’ll break it down for you.

Why do mortgage lenders request tax returns?

Your tax returns, along with the other financial documents. in your mortgage application, are used to determine how much you can afford to spend on your home loan every month. Because a mortgage commits you to years of payments, lenders want to make sure your loan is affordable to you both now and years down the road.

To help calculate your income, mortgage lenders typically need:

  • 1 to 2 years of personal tax returns
  • 1 to 2 years of business tax returns (if you own more than 25% of a business)

Depending on your unique financial picture, we might ask for additional paperwork. For example, if you have any real estate investments, you may need to submit your Schedule E paperwork for the past 2 years. If you’re self-employed, you may have to provide copies of your Profit and Loss (P&L) statements. On the other hand, if you’re not required to submit tax returns, lenders may be able to use your tax transcripts instead. If you are self-employed, a business owner, or earn income through other sources (such as rental income or significant interest income), you’re more likely to be asked for your tax returns along with additional paperwork. Here’s a guide to what documents lenders might need for your specific situation.

What numbers are mortgage underwriters looking at on your tax returns?

Your tax documents give lenders information about your various types and sources of income and tell them how much is eligible toward your mortgage application. Non-recurring income, such as any money received as a result of a one-off company signing bonus, a boat sale, or lottery winnings, wouldn’t typically be counted as loan-eligible income. Any income that you report on your mortgage application that isn’t reported in your tax returns usually can’t be used to qualify.

Keep in mind that certain tax deductions may also decrease your income for loan purposes. However, deductions for things that don’t actually cost you anything (like depreciation expenses) won’t reduce your borrowing ability. So, while taking numerous deductions might save you on your taxes (especially if you’re self-employed), it can significantly reduce how much you can be approved for by lenders.

The type of income you earn also determines the way underwriters evaluate it. For example, there are different factors that determine how self-employment income is calculated such as the business structure (sole proprietor, partnership, or corporation), percent ownership, and how long the business has been owned. Typically a mortgage underwriter averages two years of the business’s net income less depreciation to determine an average monthly income.

Once we calculate your loan-eligible income, we’ll use that number to determine a couple of things:

    Your debt-to-income (DTI) ratio

    Your debt-to-income (DTI) ratio gives lenders an understanding of how much of a monthly mortgage payment you can afford in addition to your current debt responsibilities without financial difficulty. It is calculated by taking your current monthly debt payments (credit card bills, car payments, student loans, etc.) plus your future monthly mortgage payment and dividing it by your gross average monthly income -- then multiplied by 100 to get the DTI expressed as a percentage.

    For example, if your debt payments with your new mortgage totals $2,200 per month and your gross income is $5,000 per month, your DTI is 44%.

    Better Mortgage can typically work with creditworthy borrowers with DTIs of up to 50%. However, the lower your DTI, the more financing options will be available to you.

      Your income stability

      We’ll also be looking to see that your income has been consistent over 2 years, and that it will likely remain stable in the future. That way, we can make sure that you’ll be able to comfortably afford your mortgage in the long run. If we see decreasing year-to-year income, changes in your pay structure, recent job switches, or other fluctuations, then we might ask for additional documentation. (You can learn more about how lenders consider your employment income here.)

    How to prepare your tax returns for a smoother mortgage process

    If you’re looking to purchase a home or refinance a mortgage in the first half of the year, then it might be a good idea to file your tax returns earlier rather than later to prevent any delays in your mortgage process. It can take the IRS 3 to 8 weeks to process your taxes, depending on how you file.

    If your mortgage application relies on your income information for that year, we may have to wait for that tax return to be processed by the IRS before we can consider that income for your loan. This is especially important if you’re self-employed, or if you need that year’s income to prove 2-year earning history.

    Talk to a Mortgage Expert today

    Have questions about exactly how your tax returns will affect your mortgage application? Talk to one of our licensed Mortgage Experts and get some clarity.

    Get pre-approved

    This publication is designed to provide general information. It is not intended to provide, and should not be relied upon, for tax, legal or other financial advice.

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