Effective income is any income that the Federal Housing Administration (FHA) uses to qualify a borrower for a mortgage. It’s often the gross income that is found on tax returns and may include salary, hourly wages, overtime pay, tips, commissions, and more. Effective gross income (EGI) relates to rental property income minus any vacancies or unpaid rents.
Here’s a closer look at what effective income is, how it compares to total annual income, and how it works in relation to FHA home loans. We’ll also explain how it relates to rental properties so you can be prepared if you ever decide to become a landlord.
Definition and Examples of Effective Income
When the FHA looks at your effective income to determine whether to grant you an FHA loan, it considers the gross income that is found on your tax return. This income may come from a variety of sources such as your salary, hourly wages, overtime, bonuses, tips, and commissions. The FHA will also consider any employer-provided mortgage assistance.
You will need to prove your work history and income for the past two years through employment verifications, W-2 forms, and paystubs. If you’ve changed your employer or line of work within a year, the FHA may require further documentation and verification.
The FHA may also consider the income you earned if you’ve worked a part-time job for the past two years and will probably continue to do so. To be approved for a loan, the FHA must believe that your income is likely to continue for at least the initial three years of the mortgage.
If you’re self-employed you’ll need to provide two years of individual and business tax returns as well as profit and loss statements and balance sheets when you apply for a mortgage.
When it comes to rental properties, effective gross income (EGI) is the potential gross rental income you can earn minus any vacancies, renovation costs, or unpaid rents.
How Does Effective Income Work?
Essentially, effective income is any income that you’re actually earning when you apply for an FHA mortgage. It can give the FHA a good idea of what kind of borrower you may be and whether you’ll be able to repay your loan.
Let's pretend you’ve worked an inside sales job at an office supply company for the past five years. When you look at documents that show your earnings, you notice the following numbers:
- Salary: $47,000
- Commissions: $6,500
- Bonuses: $3,200
In this scenario, your effective income is the total of those three numbers, or $56,700.
When it comes to rental properties, your EGI is the income a property earns plus income from other sources. If you own a rental property, it’s the total of all the money you collect from things like rent, late fees, vending machines, laundry machines, parking fees, pet fees, and more after you subtract all current or predicted vacancies and credits.
For example, if you rent a one-bedroom condo to someone for $1,000 per month, you may expect to bring in an EGI of $12,000 per year ($1,000 x 12 months). However, if that person doesn’t pay their rent one month, then the actual EGI from that rental property would be $11,000 for the year. Two rental properties with the same monthly rent price could result in different effective incomes if tenants vacate the property, rent goes unpaid, or something else happens and income is lost.
Effective Income vs. Total Annual Income
|Effective Income||Annual Income|
|Any income that the FHA uses to qualify a borrower for a mortgage||Determines a family’s eligibility for assisted housing|
|Calculates a rental property’s cash flow from all sources of income like rent, late fees, vending or laundry machines, parking fees, and more, minus all current or predicted vacancies, unpaid rents, or other lost income||Includes monetary and non-monetary income sources earned by family members and expected income from outside family sources during the 12 months after admission or annual recertification|
As mentioned above, effective income can apply to the calculation the FHA uses to determine your eligibility for a mortgage. Effective gross income (EGI) relates to rental properties and can include much more than just rent.
Annual income is what is used to determine whether a family is eligible for assisted housing. It includes all income (both monetary and not) that is received by family members as well as all income that is expected to be received from outside family sources during the 12 months after the admission or annual recertification date. As a rental property owner, it’s your responsibility to figure out a family’s annual income before you allow them to move into assisted housing.
- The FHA looks at your effective income when determining your eligibility for one of its home loans.
- Effective income may include your salary, hourly wages, overtime, bonuses, tips, commissions, and employer-provided mortgage assistance.
- You will need to submit a variety of documents, including your Form W-2 and paystubs, to prove your effective income to the FHA.
- Effective gross income (EGI) relates to the total income from a rental property, minus money lost from vacancies, unpaid rents, or other costs.
Frequently Asked Questions (FAQs)
What are the benefits of an FHA loan?
Compared to a conventional mortgage, an FHA loan comes with requirements that may be easier for first-time or low-income homebuyers. If you qualify, you may be able to buy a house with as little as 3.5% down.
What are the FHA guidelines for income and debt ratios?
The FHA requires potential borrowers to have a debt-to-income ratio (DTI) of no more than 43%. There are no minimum or maximum salary requirements that will qualify you or prevent you from getting approved for an FHA home loan. To calculate your DTI, add up all your monthly debt payments and divide that number by your gross monthly income.
Which expenses are deducted when calculating effective gross income?
When determining effective gross income, expenses, including unpaid rent and vacancies, are deducted. These deductions should be subtracted from the total annual rental income earned.
U.S. Department of Housing and Urban Development. "HUD 4155.1- Borrower Employment and Employment RelatedIncome." Accessed May 25, 2021.
U.S. Department of Housing and Urban Development. "Handbook 4000.1." Accessed May 25, 2021.
U.S. Department of Housing and Urban Development. "Chapter 5. Determining Income and Calculating Rent." Accessed May 25, 2021.
U.S. Department of Housing and Urban Development. "Let FHA Loans Help You." Accessed May 25, 2021.
U.S. Department of Housing and Urban Development. "Borrower Qualifying Ratios." Accessed May 25, 2021.