What Is Residual Income in Mortgage?

Residual income represents the financial breathing room an individual or household has each month after covering all essential expenses and debt obligations. In a general financial context, it is the discretionary income available for savings, investments, or non-essential spending. For those seeking a mortgage, residual income takes on a specific and important role as lenders use it to assess a borrower’s capacity to manage daily living costs once housing expenses are factored in. This metric helps determine if a borrower can comfortably afford a new home without facing undue financial strain.

Defining Residual Income for Mortgages

For mortgage applications, residual income is the money a borrower has left after paying all significant debts and estimated living expenses, including the new mortgage payment. Lenders use this to evaluate financial stability and ability to cover non-housing costs, which helps reduce loan default risk. It also provides insight into a borrower’s capacity to absorb unexpected expenses or maintain a reasonable quality of life.

Residual income differs from the debt-to-income (DTI) ratio, though both are used in lending decisions. A DTI ratio focuses on the percentage of gross monthly income that goes towards debt payments. Residual income, conversely, considers a broader range of actual living expenses beyond just debt obligations, providing a more comprehensive picture of a borrower’s discretionary funds. While DTI assesses debt capacity, residual income focuses on the practical affordability of daily life post-mortgage. This distinction is relevant for certain loan types that emphasize financial flexibility.

Calculating Residual Income

Calculating residual income involves assessing a borrower’s income and expenses. Lenders begin with the borrower’s gross monthly income, encompassing all verifiable sources of earnings. From this gross income, various mandatory deductions are subtracted. These commonly include federal and state income taxes, Social Security, and Medicare contributions.

Following tax and mandatory payroll deductions, existing debt payments are subtracted. This includes regular monthly payments for credit cards, auto loans, student loans, and any other installment or revolving debts reported on a credit report. The proposed new mortgage payment, which includes principal, interest, property taxes, homeowner’s insurance, and any applicable homeowners association (HOA) fees, is also deducted.

Lenders then subtract estimated living expenses from the remaining income. These estimated expenses are based on standardized tables, often varying by factors such as family size and geographic region. For example, the Department of Veterans Affairs (VA) provides specific guidelines for these estimates. These living expenses cover necessities like food, utilities, transportation, and healthcare costs.

Lender Considerations for Residual Income

Lenders use the calculated residual income in their mortgage approval process. While residual income is a metric, it is commonly used in conjunction with other qualification standards, such as debt-to-income (DTI) ratios and credit scores. This provides a holistic view of a borrower’s financial health and their capacity to manage a new mortgage.

Certain loan programs, particularly VA loans, emphasize residual income. The VA sets specific residual income guidelines that vary based on family size and the region of the country, reflecting differing costs of living. These guidelines ensure that veterans and active-duty service members have adequate funds remaining for everyday expenses after their housing costs are covered, reducing the likelihood of financial hardship and loan default.

A higher residual income indicates a stronger borrower profile. Even if a borrower’s DTI ratio is on the higher side of acceptable limits, sufficient residual income can serve as a compensating factor, improving the chances of loan approval. This shows the lender that despite higher debt obligations, the borrower possesses enough discretionary funds for ongoing living expenses.