When you were working, calculating your income for the purposes of securing a loan was easy. But with retirement accounts, it can be slightly more complicated. However, if you understand the basic math, you can use IRA distributions for the purchase of a world-class home that will keep you happy all through retirement.
IRA Distribution Income: Not a Dollar-for-Dollar Equation
IRA distributions can have a strong impact on your overall income, adding a valuable source of money to your budget; in some cases they may even represent your entire income. Obviously if you are bringing this money into your bank account, you should be able to use it as income for a loan application, including mortgage loans. You can, but not in a simple format. (At least, not as simple as before.)
With traditional paychecks, wages, and salaries, you could essentially use the exact earnings as your income towards a loan. If you earn exactly $120,000 a year during your working career, on your loan application you could put down (in most cases) an annual income of $120,000.
Simple, clean, and easy.
But the same can’t be said for IRA distributions. For IRA distributions, you are able to use 70% of the income minus roughly $10,000. Unfortunately, you can’t use the entire 100%.
Let’s look at a simplified example to see how this can work. Suppose you have an IRA retirement account with a certain amount of money. 70% would be available as a qualifying income. But it doesn’t end right there, as there are other factors that need to be considered before you can reach the final number. To take into account closing costs and other fees, another $10,000 is removed. That number is then divided by 360, which is the total number of payments made on a 30-year loan. (There are 360 months in 30 years.) Once the division is made, you have the final number that can be added to your income.
Does that sound confusing and complicated? It’s really not; if we take a specific example and break it down step-by-step, you’ll see that calculating the income from IRA distributions is quite simple.
IRA Distributions: A Step-by-Step Example
Starting Point: An IRA with $2 Million
Let’s start with a simple, round number. Suppose we are looking at an IRA account that has exactly $2 million as a balance.
- Number: $2,000,000
Step 1: Calculate 70% of the Balance
Now we will take the $2 million dollars that are currently in the IRA account and subtract 30%. This will give us the 70% that we need to move forward.
- Math: Determine 70% of $2,000,000
- Number: $1,400,000
Step 2: Subtract $10,000 for Fees and Costs
Taking out a mortgage and closing on a home costs money, usually around $10,000 when all is said and done. To factor in these costs, the calculation will next remove $10,000 from the previous number.
- Math: Subtract $10,000 from $1,400,000
- Number: $1,390,000
Step 3: Divide by Total Number of Months on the Loan
Now we can divide by the total number of monthly payments that will be made on the loan. Assuming a 30-year loan, this means there will be 360 payment; if the loan is a 15-year, it would be divided by 180.
- Math: Divide $1,390,000 by 360 (Assuming 30-year mortgage.)
- Number: $3,861.11
Result: Add $3,861 to Your Qualifying Income
After you complete the steps above, you will be able to add roughly $3,861 to your total qualifying income. This can be extremely useful for helping you qualify in many ways. For one, it can improve your debt-to-income ratio, possibly moving you into percentages where you actually qualify or can enjoy a better interest rate. It may also allow you to purchase a better, larger, or more luxurious home, the home you worked so hard to buy during your career.
Why 70%, and Not the Full Amount?
Reducing the total by $10,000 (Step 2 in our example above) is easy to explain. This is taken out to accommodate for fees and closing costs, which come with virtually every home purchase, especially those that use a mortgage. (Which is most mortgages.)
But what about the reduction of 30% from the initial total? (Step 1.) Why does the amount need to be reduced by such a large percentage? Why is 70% used and not the full amount?
Because of market fluctuations.
Money in an IRA account is invested in the market, which means it is subject to the ups and downs of the national and global economy. If it were sitting in a bank account, the $2 million that we referenced above would not change (assuming it’s not withdrawn), but with money in an investment account, it could go down based solely on market changes. While it’s more likely to go up over an extended period, in the short term it could go down.
For this reason, lenders use the 70% rule, which helps them compensate for the potential reductions from the market.
Other Rules for Using this Income to Qualify
Now that you understand the equation, and you probably realize that the math is not as complex and intimidating as you thought, it’s time to put your income to good use. To do so, you should understand some of the basic rules for using IRA income to qualify for a mortgage.
To use the account, you must be at least 59.5 years of age and have a sufficient balance for a three-year continuation of the income distribution. You will also need to have unrestricted access to the account so you can get the cash if needed. The income distribution will need to have started before the application date, and you should have received at least one payment before the final approval.
Use IRA Distributions on Your Next Home Loan
If you meet these requirements, you can likely use your IRA distributions as an income on your next loan. Contact the team at San Diego Purchase Loans and learn how we can help you use all of your potential income sources towards the purchase of a wonderful property.
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