Attorneys, CPAs, doctors, partnerships, salespeople, proprietors, professionals, corporations.
Self-employed
borrowers represent one of the most complex and challenging areas of
underwriting. Qualifying self-employed people often requires time, energy, and
patience. A fair and honest qualification can only be given after this critical
review has been done. Conducting a thorough examination of their business
structure and tax documents to determine qualification
requires a special set of skills.
I have had much success with this specialized section of the marketplace. Everything I read indicates the trend toward at-home-businesses and the downsizing in corporate America. We must learn to accommodate these newly self-employed borrowers with mortgages, or we will be missing a large part of the home buying market!
GENERAL GUIDELINES FOR SELF-EMPLOYED BORROWERS
Most mortgage companies underwrite their loans to guidelines established by the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal Housing Administration (FHA), or the Veterans Administration (VA). Each of these organizations shares similar underwriting guidelines for self-employed borrowers. In addition, some lending institutions have non-standard sources to draw on for the purpose of making loans to borrowers who do not specifically fit these guidelines.
Listed below are some of the standard guidelines that pertain to employment and income.
- Two or more years of self-employment are required (less than two years may be acceptable if the borrower has had at least two years' previous employment or a combination of one year's employment and formal education or training in a related occupation. Less than one year of self-employment is generally not acceptable).
- Borrowers are considered self-employed if they own 25 percent or more in a business (detailed information is provided later).
- A two-year minimum average income is needed to determine qualifying income. This is done to even out fluctuations common to self-employed borrowers.
- A positive overall economic outlook in the area for the particular type of business is considered.
- There should be no significant decline in income over the period analyzed (an exception to this is discussed under Things to Remember).
QUESTIONS AND ANSWERS
1. Are self-employed borrowers qualified differently than salaried borrowers?
Self-employed borrowers are evaluated the same way salaried borrowers are-by determining if the borrower has sufficient income to support the mortgage payment and a willingness to repay all debt, evidenced by a credit report. However, the methods used in the analysis of the self-employed borrower's income are different.
In most cases, a salaried borrower's gross salary is used for qualification. This method is not adequate for the self-employed because the daily operation of the business must be supported by gross receipts along with income to the owner. This requires analyzing the borrower's federal tax returns and other schedules, depending on the type business, to determine net income to the borrower.
The growth, viability, and stability of the business field is also critical in determining the ability of the borrower to meet on-going obligations. The length of time self-employed and overall experience in the field must be considered. Because of the subjective nature of underwriting these loans, it is important for the borrower and the loan officer to put together a narrative along with documentation to support the income claim needed for the transaction.
2. Who needs to be qualified as a self-employed borrower?
Typically,
borrowers who are receiving variable income, which they wish to use as
qualifying income, must have their tax returns reviewed. This includes sole
proprietors, borrowers owning 25 percent or more of a partnership, corporations
or S corporations, commissioned salespeople (even though they may receive W2's
from their employer), and people who receive annual
1099's to substantiate their income.
3. What documents are required from the borrower?
The type of business the borrower has will determine the documents needed. Documents needed for different business structures are listed below.
Sole
Proprietorship
- U.S. Federal 1040 with all applicable schedules attached
- Schedule C (Profit and Loss from Business)
- Schedule D (Capital Gains and Losses)
- Year-to-date Balance Sheet and Profit and Loss Statement
Partnerships (General and Limited)
- U.S. Federal 1040 with all applicable schedules attached
- Schedule E, Part II (Income or Loss from Partnerships)
- Schedule K-1 1065 (Partner's Share of Income, Credits, Deductions, etc.)
- Form 1065 (U.S. Partnership Return of Income) with all applicable schedules
attached
- Year-to-date Profit and Loss Statement
- Partnership Agreement (may be required)
S
Corporation
- U.S. Federal 1040 with all applicable schedules attached
- Schedule E, Part II (Income or Loss from S Corporations)
- Schedule K-1 1120S (Shareholders' Share of Income, Credits, Deductions, etc.)
- Form 1120S (U.S. Income Tax Return for an S Corporation) with all applicable
schedules attached
- Year-to-date Profit & Loss Statement
Corporation
- U.S. Federal 1040 with all applicable schedules attached
- Form 1120 (U.S. Corporate Income Tax Return) with all applicable schedules
attached
- Year-to-date Profit & Loss Statement
4. Is a minimum down payment required for self-employed borrowers?
There are several new loan programs available today. Lenders are doing their best to qualify people with the lowest rates, lowest down payment, highest qualifying ratios, and the fewest verifications and documents. Most loan programs have the same requirements for different types of employment. Programs are available for first-time homebuyers, move-up buyers, or investors-regardless of their employment. However, some loan programs require more strict guidelines for self-employed borrowers. Consult me for specific details.
5. What if a borrower can't qualify because tax write-off amounts decrease his new income too much?
This is a common problem among self-employed borrowers. They are making enough money to pay the new mortgage and they have had steady income for years, but tax write-offs lower their reported income. Despite their income, they get penalized when they want to buy a house. They don't qualify! Lenders look to see if the borrower has enough independent income to pay the mortgage and other debt obligations. New income from their tax return is not the final determining factor. The tax returns need to be reviewed and analyzed carefully. Some tax write offs can be added back to the new income. If the new amount does not qualify the borrower, no income verification loans may be an option. Consult me for loan guidelines.
6. How many tax returns should be used to arrive at the average qualifying income?
It's best to use
two years of tax returns. This will stabilize the fluctuations in cash flow that
may occur due to the normal ups and downs in many businesses. If an analysis of
tax returns shows that the applicant has a pattern of reasonable increases in
income each year, it makes sense to use the most recent year's tax return alone.
A reasonable increase would be in the range of 10 to 20 percent per year. An
increase of 40 to 50 percent in one year over the past year is not a
reasonable increase and may well represent some sort of windfall to the business
that may not be maintained over the long term. A 24-month average would then be
more logical to stabilize the income. Remember, common sense prevails in most of
these decisions.
7. What about newly self-employed applicants?
Newly self-employed applicants represent a special situation. The cliché, the first year you take all your clients with you, and the second year you go out of business, rings true with many underwriters. It is our job to make a very strong case to the contrary. Verifying previous employment helps to determine a track record of skills, length of employment, and work attitude. The previous income helps establish the financial history, as well as indicates whether the move to self-employment represents logical progress or a complete departure from an established profession.
THINGS TO
REMEMBER . . .
- If the borrower recently had a bad year but had previous successful years,
qualification is still possible.
- A bad year may result from several causes-divorce, death, or medical illness.
This could happen to anyone at any time. If the business had previous successful
years, don't assume the individual can't be qualified.
- If financial statements are required in the middle of a tax year, encourage
the borrower to start with a year-to-date statement of the Profit and Loss. This
statement does not need to be audited if the income is no more than 25 percent
greater than the previous year. If the income is 25 percent greater than the
previous year, an audited statement will be required.
HOW TO BEGIN
Contact a qualified Home Loan Specialist who is familiar with analyzing tax
returns to qualify self-employed people. Have the last 2 to 3 years' tax returns
and year-to-date figures ready for the loan officer. Ask the Home Loan
Specialist exactly what documents you will need for the borrower's particular
case. I hope this publication has given you the idea that I have experience with
the self-employed borrower. There is an art to getting these loans approved, so
not everyone will be able to help you!!
CONCLUSION
You must be willing to spend some time working with me to qualify if your
particular situation does not fall within the guidelines. My lenders are willing
to spend the extra time and effort to correctly qualify self-employed people.
Careful review of tax documents cannot be done accurately over the phone. There
is too much room for error. Qualifying self-employed borrowers correctly-the
first time-will save everyone time, money, and frustration.
Call me for the names of excellent loan officers in the