What do mortgage lenders look for on your tax returns?

Matty Kimura (NMLS ID: 1569434)
By Matty Kimura (NMLS ID: 1569434)

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

Why do lenders need your tax returns?

Your tax returns, along with the other financial documents in your mortgage application, are used to determine exactly how much you can afford to spend on your mortgage every month. Because a mortgage commits you to years of payments, we want to make sure your loan is affordable both now and later in life. While getting a snapshot of your current finances is a good start, we also need to predict your future ability to pay.

Lenders will typically need:

  • 1-2 years of personal tax returns
  • 1-2 years of business tax returns (if you own more than 25% of a business)
  • 1-2 years of W-2s or 1099s

Depending on your unique financial picture, we might ask for additional paperwork. For example, if you have any real estate investments, we may need to see your Schedule E. Or if you’re self-employed, you may have to provide a copy of your Profit and Loss (P&L) statement. If you’re not required to submit tax returns, we may be able to use your tax transcripts instead. Here’s a guide to what documents lenders might need for your specific situation.

What numbers are mortgage underwriters looking at?

Your tax documents give lenders proof of your various sources of income and tell them how much of that income is loan-eligible. Any income that you report on your mortgage application but isn’t actually listed in your tax returns can’t be used. Keep in mind that certain tax deductions may also decrease your income for loan purposes. However, tax 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 lenders can approve you for.

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

  1. Debt-to-income (DTI) ratio: Your DTI ratio gives us an understanding of how big of a monthly mortgage payment you can afford without financial difficulty. It is calculated by taking all your monthly debt payments, including your future mortgage payment, and dividing it by your average monthly income. Better Mortgage can work with creditworthy borrowers with DTIs of up to 50%. However, the lower your DTI, the more financing options will be available to you.

  2. Income stability: We’ll be looking to see that your income has been stable and consistent over a 2-year period and likely to continue into the future. That way we can make sure that you can comfortably afford your mortgage in the long run. We might ask for additional documentation if we see decreasing year-to-year income, changes in your pay structure, recent job switches, etc. (You can learn more about how lenders consider your employment income here.)

Is there any way to prepare your tax returns for a smoother mortgage process?

If you’re looking to purchase or refinance a house in the first half of the year, it might be a good idea to file your tax returns earlier rather than later to prevent any delays in your mortgage process. As you may know, it can take the IRS 4-8 weeks to process your tax filing. If your mortgage application depends 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 get 2-year earning history.

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.

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