One of the issues mortgage lenders regularly encounter in divorce situations is the distinction between income and “qualifying” income, as defined by mortgage underwriting guidelines. Although ALL sources of income are considered “income” by the recipient, it is important to understand that from a mortgage financing perspective, not all sources of income are considered qualifying income.
Why should this matter to you? Simple. If your client will need mortgage financing after the divorce is final, involving a mortgage professional who specializes in Divorce Mortgage Lending during the divorce process, rather than post-decree, can help to ensure your client can perform on the agreement between the parties.
There are five major types of income to consider:
- Employment Income
- Child Support Income
- Spousal Support Income
- Property Settlement Note Income
- Asset Income
To be considered qualifying income, certain requirements must be met. In this post, we will review the first three types of income, as they are most important to understand. I will cover Property Settlement Note Income and Asset Income in the next post.
Let’s look at the first three sources of income, as they applied in the case of Mary, a client recently referred to me by her financial planner. Mary met with me to determine if she could refinance the home she wants to keep.
Here are the facts:
- Husband is living in the marital residence, with an approximate equity position of $300,000. The home will be sold, and the proceeds split 50/50, or $175,000 each.
- Mary is living in a second owned property that she wants to keep. The mortgage balance is approximately $174,000, with a monthly payment of $1,725.
- The mortgages on both properties are in the husband’s name. Husband will require mortgage on second property to be paid off within a “reasonable” time period.
- Mary has been a homemaker for 20 years. She has just completed an associate’s degree and expects to earn a starting salary of $35-40,000.
- Other than the mortgage she intends to assume, Mary has no debt.
- At this point, I am not privy to other assets that could impact the settlement.
Underwriters look at two key principles when establishing income as qualifying income: Stability and Continuance. Let’s look at how they would view Mary’s Employment, Spousal Support, and Child Support incomes to determine if they would be “qualifying” income.
EMPLOYMENT INCOME
Underwriters define “stability” as two years of employment history in the same or related industry. If they see a spotty work history with lots of employment gaps, it suggests the borrower may not be stable, and therefore a risk in repaying the proposed debt obligation. For a full-time, W-2 type employee, however, it is okay to change jobs if the person stays in the same field.
People who are self-employed or who receive significant commission or bonus income are a different story. Underwriters want to see a 2-year track record of self-employment (such as someone working on a contract basis), commissions, or bonus income from the SAME employer.
There is one exception. If the borrower has been in school, whether college, junior college, or a technical school, this time can count toward the two-year history as long as the borrower is now working in the same field. For example, when a student completing a 4-year degree in engineering accepts a salaried position with an engineering firm, he or she would qualify with 30 days of pay stubs and the college transcript.
What About the Stay-at-Home Parent?
In many divorces, there will be a stay-at-home mom who left the workforce for an extended period of time. In these situations, the underwriters want to see a current six-month work history (must be full-time salaried or hourly, not contract). We still must verify two total years of employment, but we can go back to work history gained prior to her leaving the workforce. If you have clients who fall into this category, please encourage them to obtain employment as soon as possible, to shorten the waiting period for their income to become “qualifying.”
How does this affect Mary? To start, Mary must obtain employment in her field of study. But her associate’s degree does satisfy the two-year employment history requirement. Next, we need to look at her debt ratio. Let’s assume her starting salary is $37,500, or $3,125 per month. With no other debt, dividing her $1,725 house payment into her salary gives her a debt ratio of 55 percent. This ratio is too high for approval on a Conventional loan (which has a hard maximum of 45 percent). However, it might be possible to make this work with an FHA refinance (which will go up to 55 percent with good compensating factors). Alternatively, she could use some of her proceeds from the sale of the other home to reduce the principal amount of the refinance so that the debt ratio is under 45 percent, to qualify for the Conventional loan.
CHILD/SPOUSAL SUPPORT INCOME
Child support and spousal support have the same guidelines. For support income to meet the qualifying income test, it must be received and documented for six months (stability) and continue for 36 months after the mortgage is obtained (continuance). We call this the 6/36 Rule. The continuance requirement for child support income is pretty straight forward. It terminates when the child turns 18 or graduates from high school. If a child is 14, it may give some incentive to complete the divorce faster if that income is important to qualify. Regarding spousal support, it could strategically make sense to negotiate a longer term of payment in order for the client to use this income to qualify. For example, instead of receiving a lump sum award of $150,000, a settlement could be structured to receive $75,000 up front and $1,250 per month spousal support for 5 years (60 payments x $1,250 = $75,000). Obviously, you would want to insure the payer’s ability to make the payments in the event of death or disability.
The six-month receipt waiting period can start prior to the divorce being finalized. For example, temporary orders may stipulate this. Make sure the temporary orders amount is not less than what is expected in the final settlement, and that it is documentable (e.g., a check written from one spouse’s individual account and deposited in the other spouse’s individual account.)
There is one important thing to keep in mind regarding the 6/36 Rule. Six months receipt of support payments is the minimum requirement, and is typically determined by the automated underwriting findings of either Fannie Mae or Freddie Mac. When the support income is greater than 30 percent of the total gross income used to qualify, it is likely that Fannie or Freddie will require 12 months receipt.
In Mary’s case, due to her children having reached the ages of 18 and 20, she won’t receive child support. There will likely be some spousal support. If structured like the example above, Mary’s debt ratio could be 39 percent ($1,725 divided by $3,125 + $1,250), which would easily fit Fannie/Freddie guidelines.
BOTTOM LINE
The good news for Mary is that she has some options for structuring her settlement so that she can qualify to refinance. The teamwork between the attorney, financial planner, and mortgage lender can make a big difference in determining what is the best overall solution for the client.
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