Is Net Income or Gross Income Used For A Mortgage?

Question

Hello,

I am looking to get financing on my first deal. I am looking at purchasing a multi-family apartment (max of 4 unit) through the FHA program.

I am 22 and self-employed. My gross income is a lot higher than my net income. I talked to a lender at ifreedomdirect.com and they said that my front-end ratio for a mortgage can be a maximum of 31% of my NET INCOME and the back end ratio is 43%.

I know that I will be able to afford the monthly payment, however my net income is not high enough to make the 31% front end ratio calculation.

Does anyone know if any lenders use the total GROSS INCOME instead of using my NET INCOME or Adjusted Gross Income? I am self-employed and obviously claim all of the legal expenses that I can in order to reduce tax obligations.

If not, does anyone else know any other ways to finance my first deal? I would hate to wait another 1-2 years to make my first deal just because my finances (on paper) are not in line yet.

Craig

Dion DePaoli · Answer

I think you have been confused by what your lender said. In residential mortgages there are two Debt to Income (DTI) calculations that evaluate your capacity as a borrower to repay your debt. Front End Ratio: Total Housing Payment divided by Gross Monthly Income (total housing includes mortgage payment, taxes, insurance and hoa where applicable) The lender told you for the program your front end ratio must be 31% or less. That is a standard conventional front DTI number. FHA is a little higher at 35%. Back End Ratio: Total Housing Payment plus all other credit debts divided by Gross Monthly Income That is where I think you were confused. When the lender said "Net" they mean the net of your Gross Monthly Income less all other credit. The accounts which contribute to the calculation are on pages 2 to 3 of your 1003 (loan application). They are pulled from your credit report. So if you have a car loan and a credit card those two line items will show up. The monthly payment for those two accounts will be added to the Total Housing Debt and divide by your income. That is your back end ratio. The 43% number is the standard conventional DTI. Again, FHA can go a little higher at 50%. The self employment situation you have adds to the mix here. We do not know from your post how you file your taxes. It sounds like you flow it all through your personal taxes, which is fine. We do not know if you take itemized expenses or standard deductions, either of which are fine. The lender is going to collect two years of your tax returns. Fannie Mae has a pretty easy to use Self Employed Income Analysis Worksheet (referred to as form 1084) you can find it here. Use that derived from your own tax returns and you will have essentially the same answer the underwriter will get when they process your loan. If you are unsure of what a particular line means, use the Internet to look up the accompany directions for the worksheet which are on Fannie Mae's website. They are very detailed and will explain away any question you have. More than likely most of the form will be blank based on what it sounds like your tax filing situation is.

John Stevenson · Answer

Dion DePaoli thank you very much for your clear post. I think you may have hit the nail on the head. It is important to understand what is meant by the Front End and Bank End Ratio and how lenders look at these numbers to determine loan qualifications. It is a shame that many lenders fail to educate their applicants/consumers about lending practices and how credit card debts, student loans, car payments etc can affect their loan qualifications. If they had spent a little more time in education, perhaps this lending crisis would not have been so sever.

John Stevenson · Answer

Do you have profit and loss statements that you used to file your taxes? These will show the actual expenses and not just the ones to reduce your taxes. You can use these to "explain" your tax returns. Another option is to incorporate your business and pay yourself a salary. This creates a W-2 and simplifies your personal return. But... this is a down the road strategy and does not solve the problem right now. Another way to finance your deal is to try to get the property owner to sell the property on a land contract. You can make this appealing by offering a high down payment (10 - 20%). There would be a balloon after 3 - 5 years which gives you time to qualify for a loan.

Jeff S. · Answer

Front and back end might refer to percentage you can afford for the payment of PITI for the 31% and 43% for all your debt payments combined. This would be gross, or pretax. Not sure though with FHA. FHA used to use net income somewhere in the area of 50% but don't believe they use that anymore. Pretty sure 31% of net is incorrect.

Craig S. · Answer

Hi Jon, Thanks for the reply. I run an insurance business/agency where I get paid 100% commission. My only real expenses are office rent, phone & internet, office supplies, licensing, and marketing being the biggest. I don't want to fool around with refiling past taxes so I guess the best thing is to wait more time until my net income is higher or I have the money to pay cash for a deal or at least a larger down payment. Craig

Jon Holdman · Answer

The lender uses your pre-tax income. But I'm not sure that answers your question. They're not going to use the gross receipts from retail business, for example. They would use the net after the cost of good sold and all expenses are deducted. So, in your case, net income may be closer. If you have some sort of business where you bring in a lot of revenue but have a lot of expenses to generate that revenue, then you can't really apply that revenue to pay the mortgage. You could always refile your past tax years. That might incur a tax bill, though.