Chapter 9: Capacity – Income and Employment Analysis
Overview
Capacity refers to the borrower’s ability to repay the
mortgage loan based on current and future income. It is one of the Four C’s of
underwriting (Credit, Capacity, Capital, Collateral). This chapter focuses on
the evaluation of income sources, employment stability, documentation
requirements, and debt-to-income ratio (DTI) calculations.
Section 1: Principles of Capacity Analysis
1.1 Key Objectives
- Determine
stable and sufficient income to support new housing payments and debts
- Verify
income sources as legal and ongoing
- Analyze
employment history for stability
- Calculate
accurate DTI ratios
1.2 Underwriting Philosophy
- Capacity
should be consistent, reliable, and expected to continue for at least 3
years
- Underwriters
must use conservative estimations
- Income
must be well-documented and verifiable
Section 2: Employment and Income Documentation
2.1 Standard Requirements
- Paystubs
(most recent 30 days)
- W-2s
(2 years)
- Tax
Returns (if applicable, usually 2 years)
- Verification
of Employment (VOE)
- Written
explanation for employment gaps >30 days
2.2 Acceptable Employment Types
- Full-Time
(W-2)
- Part-Time
- Seasonal
- Self-Employed
- Military
- Union
Workers
- Contract/Gig
workers (case-by-case)
2.3 Unacceptable Income Sources
- Income
not reported on tax returns (unless allowed by program)
- Unverifiable
cash income
- One-time
bonuses or gifts
- Short-term
disability or unemployment
Section 3: Income Types and Calculations
3.1 Salary and Hourly Wages
- Base
Pay: Use current rate if consistent for past 12+ months
- Hourly
Pay:
- Multiply
hourly rate × average hours/week × 52 weeks ÷ 12 months
- Overtime
and bonuses must have a 12–24 month history
3.2 Bonuses and Overtime
- Must
be consistent and likely to continue
- Average
over past 2 years from W-2s or paystubs
- Employer
VOE may support continuation
3.3 Commission Income
- Typically
requires 2-year history
- Must
be stable and show consistent or increasing trend
- Review
Form 2106 for unreimbursed business expenses if applicable
3.4 Part-Time or Second Jobs
- Must
be held for 12+ months concurrently
- Likelihood
of continuance must be supported by employer VOE
3.5 Self-Employment Income
- Documentation:
- 2
years personal and business tax returns
- Year-to-date
Profit and Loss (P&L) statement
- Balance
sheet (if required)
- Analysis:
- Use
adjusted gross income from Schedule C (or business returns)
- Add
non-cash deductions (depreciation, depletion)
- Subtract
recurring business expenses (e.g., meals, interest, car)
3.6 Rental Income
- Lease
agreements or tax returns (Schedule E)
- Must
prove ownership and occupancy (if applicable)
- Apply
25% vacancy factor unless waived by investor
3.7 Alimony and Child Support
- Must
be documented with court order or agreement
- Proof
of receipt for 6–12 months
- Must
continue for minimum 3 years
3.8 Social Security, Pension, and Disability
- Award
letters
- Proof
of receipt (bank statements)
- Continuity
for 3 years (unless due to age, i.e., retirement)
3.9 Investment or Trust Income
- 2
years of history
- Proof
of ongoing distribution
- Documentation
of source (trust agreement, investment statements)
Section 4: Employment History Requirements
4.1 General Guidelines
- 2
years of stable employment history required
- Gaps
over 6 months require strong explanation and 6 months in current job
4.2 Recent Graduates
- School
transcripts or diploma can substitute for work history
- New
job offer letter may be used if starting within 60–90 days
4.3 Job Changes
- Frequent
changes in same industry are acceptable
- Shift
from W-2 to self-employment may require seasoning (often 2 years)
Section 5: Debt-to-Income Ratio (DTI)
5.1 DTI Types
- Front-End
DTI: Housing ratio = PITI ÷ Gross Monthly Income
- Back-End
DTI: Total obligations = (PITI + Monthly debts) ÷ Gross Monthly Income
5.2 Monthly Debt Obligations Include:
- Auto
loans, credit cards, student loans, personal loans
- Alimony/child
support
- Co-signed
loans (unless excluded per guidelines)
- Housing
expense (HOA dues, property taxes, insurance, mortgage)
5.3 DTI Tolerances by Program
- Conventional
(DU/LP findings): up to 45%, occasionally 50%
- FHA:
Typically 31%/43% front/back, up to 50% with strong compensating factors
- VA:
No specific DTI cap, but residual income guidelines apply
- Jumbo:
Varies by lender, often stricter (up to 43%)
Section 6: Income Averaging and Analysis Tips
6.1 Averaging Periods
- Use
12- or 24-month averages based on trend and program
- Declining
income must be explained and may be averaged conservatively
6.2 Seasonal or Irregular Income
- Identify
season pattern
- Use
year-round average or seasonal average as permitted
6.3 Red Flags
- Sudden
income increases or decreases
- Unverifiable
sources
- Large
write-offs for self-employed borrowers
6.4 Employer VOE Review
- Confirm
position, hire date, likelihood of continuance, and compensation breakdown
- Watch
for discrepancies between paystubs and VOE
Section 7: Tools and Worksheets
7.1 FNMA Form 1005/1005(S)
- Request
for Verification of Employment
- Used
to confirm income and job details
7.2 FNMA Form 1084
- Cash
Flow Analysis Worksheet for self-employed borrowers
7.3 Freddie Mac Form 91
- Alternative
income calculation tool
7.4 Lender-Specific Income Calculators
- Automated
or Excel-based templates to standardize income analysis
Section 8: Case Studies
Case 1: Hourly Worker with Overtime
- $18/hr
× 40 hrs/week = $3,120/month
- Overtime
history averaged over 24 months = $400/month
- Total
income = $3,520/month
Case 2: Self-Employed Borrower
- Schedule
C net income: $40,000
- Add
back $5,000 depreciation
- Subtract
$2,000 recurring expenses
- Average
over 2 years = ($43,000 – $2,000) ÷ 12 = ~$3,416/month
Case 3: Recent College Graduate
- Offer
letter stating $55,000 annual salary
- Employment
start date within 60 days of closing
- Accepted
with VOE and proof of acceptance
Final Notes
- Only
use income that is stable, verifiable, and likely to continue
- Use
conservative calculations to avoid overestimating capacity
- Cross-verify
all income data points for consistency
- Keep
updated on investor-specific requirements and overlay
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