When you apply for a mortgage loan, there’s a good chance the lender will ask for copies of bank statements and tax returns. These are some of the most commonly requested documents during the loan application process.
But why? Why do mortgage lenders need to see your bank statements? And why do they want to look at your tax returns? It has to do with income and asset verification. Primarily, they do it to see (A) how much money you earn, and (B) how much you have in the bank for closing costs and down payment.
Let’s look at each of these topic individually, starting with bank statements:
Why Mortgage Lenders Need Bank Statements
When you apply for a home loan, the mortgage lender will want to know everything about your current financial situation. Among other things, they want to know how much money you have in the bank, and how long it has been in there. This is known as asset verification.
This is the primary reason why mortgage lenders need to look at your bank statements. They want to ensure that you have enough money in your account(s) to cover your down payment, your closing costs, and (in some cases) the first few mortgage payments.
Your lender might also attempt to “source” all recent deposits in your bank account. They want to know where the money came from, or the source of the funds. Basically, they’re trying to spot large deposits into your account that were borrowed from somewhere else. Generally speaking, you can’t take out other loans to cover your down payment and closing costs. That’s prohibited under most mortgage programs.
Just to be clear, using money donated by a friend or family member is generally allowed under most loan programs, including FHA. This is known as a down payment “gift.” But borrowing money for your minimum investment is usually not allowed. These are two different things entirely.
“Mystery money” (deposits for which the source cannot be found) can be a deal-breaker during the underwriting process. If you can’t show where a recent deposit came from, it might be a problem. Income-related deposits are no problem. But anything beyond that must be sourced (in most cases).
This is the main reason why mortgage lenders need to look at your bank statements. But it’s not the only reason. They also use your bank statements to see how much money you are earning, and to calculate your debt-to-income ratio.
Why They Look at Your Tax Returns
So that covers bank statements. But what about tax returns? Why do mortgage lenders need to see your tax returns when they’re considering you for a loan? It has to do with income verification.
For obvious reasons, lenders are concerned with the amount of money you earn. They want to be sure you have the financial capacity to repay the loan, based on the monthly mortgage payments. In order to determine this, they need to know your income. But they won’t just take your word for it. Not anymore.
During the housing boom, a lot of lenders were using “stated income” loans to attract borrowers, particularly those with unconventional (or even insufficient) income. Also known as “liar loans,” this is when borrowers were allowed to simply say what their income was, without having to prove it. Shocking but true. This practice has all but vanished.
Today, mortgage lenders want to look at tax returns to verify the borrower’s reported income. And they usually prefer to obtain the tax records directly from the IRS. That’s why you’ll probably have to sign an IRS Form 4506-T, which allows the lender to request a transcript of your returns from the IRS.
If the income you report on your application matches the number they see in your tax returns, then all is well. But if those two numbers don’t match, the lender will dig deeper to find out why. They’re looking for income irregularities as well as cases of loan fraud.
The ‘Ability-to-Repay’ Rule
We’ve talked about some of the practical reasons why mortgage lenders ask for bank statements and tax returns. But there’s a regulatory reason as well, and it has to do with some new lending rules that took effect in 2014. These rules require stricter income verification and are designed to prevent the kinds of reckless lending practices that led to the housing crisis.
According to the Consumer Financial Protection Bureau (CFPB), the Ability-to-Repay and Qualified Mortgage (QM) Rules “generally require creditors to make a reasonable, good faith determination of a consumer’s ability to repay any consumer credit transaction secured by a dwelling.”
A CFPB compliance guide, published in 2014, talks about the need for mortgage lenders to review bank statements:
“Your organization must verify the information you rely on using reasonably reliable third-party records. For example, you generally cannot rely on what consumers orally tell you about their income. You must verify a consumer’s income using documents…”
The federal agency includes bank statements, W-2 forms, and tax returns in its list of “reasonably reliable third-party records.” This gives lenders one more reason to check documents when considering a loan applicant.