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An increasing number of self-employed individuals has created the need for a special category of mortgage loans for self-employed borrowers. While loans for the self-employed have been around for many years, recent streamlining of some programs make the process simpler and safer for self-employed borrowers. The primary problem that self-employed borrowers face is that while their accountants are experts at reducing tax liabilities by minimizing current net income, underwriters rely on that same net income as a gauge of a self-employed borrower's earnings. Self-employed individuals are not necessarily more or less of a financial risk than employed borrowers. However, the manner in which borrowers are reviewed by underwriters for loan approvals can often make a self-employed borrower's financial position look worse than it actually is. In addition, more paperwork is usually required for conventional programs. A new batch of "no-doc" and "no ratio" loan programs for the self-employed has greatly increased the ability of the self-employed to obtain a loan without worrying about the fact that their financial records reflect neither their true business success nor their ability to repay the loan. However, since August of 2007 many of those programs have been curtailed or eliminated. Still, there are several program available for self-employed borrowers with very good credit that do not require income verification. To gain a better understanding of how much better the new programs are, it is useful to take a look at older self-employed loan programs. Under normal Fannie Mae underwriting standards, a borrower is considered self-employed if he or she owns more than 25% of a business from which income is derived. Any lower percentage ownership and a borrower can simply be considered employed by the firm. Self-employed borrowers who want to go the full documentation route must be able to provide the following: 1) two years of business tax returns; 2) two years of personal tax returns; 3) credit references for a business credit report (although that requirement has been eliminated for many programs); and 4) a year to date profit and loss statement. If there are any problems with this information, then additional documentation will be required, such as letters from accountants, business bank statements or other financial records. Many programs now also require some type of verification that the borrower is self-employed and that their business currently exists. A letter from a CPA confirming that the borrower is self-employed usually will cover this requirement. Underwriters average the net income to the business owner over the past two years to obtain an estimate of total income. For example, a borrower with net income of $50,000 in 2006 and $100,000 in 2007 will only be credited with an average of $75,000 in income during 2008, even if 2008 is on track to equal 2007. Some expenses can be added to net income such as depreciation if they are non-cash expenditures. If the averaged income is sufficient to qualify, then the borrower will be approved. Another area where borrowers can add back income is for auto expense. If your business pays your car loan, then you can exclude that car debt from your personal debts as long as you can show that the business has paid the loan for the past three months (canceled checks required). Many self-employed borrowers do not show sufficient averaged tax return income to qualify for the loan they need. For example, if a business owner suffered a difficult year in 2007, but in all years before and after income was significantly higher, then the averaging method of analyzing income would unfairly deny the borrower a standard loan. This is where the special loans for self-employed borrowers become a viable alternative. Under the typical no-income verification loan, a borrower must be self-employed for at least two years and provide proof of sufficient assets and excellent credit (As of July 2008, the minimum required score for no income verification is 680). On the loan application, the borrower either states what their current annual income is now. Because these loans carry a higher risk, the rates are usually about 1/8% to 1/2% higher than normal loan rates and the down payments depend on credit score. Self-employed borrowers with 680 or higher scores, however, can now get 75% financing for purchases and refinance loans. This is a much higher down payment requirement/equity requirement than in 2007, when borrowers could put down as little as 5% with a no income verification loan. It can appear that these loans would be perfect for the self-employed, but several catches in the program can prevent approval or come back to haunt the borrower later. Because the borrower is free to state any income, this program is open to abuse by consumers. To combat many instances of fraud encountered in the 1980's and again in the 2000 - 2007 time periods, two changes were added to most self-employed loan programs. One enhancement required self-employed borrowers to demonstrate assets in relation to their income. Some of these asset requirements became stringent, with many programs requiring a borrower to have at least 50% of their stated income in assets after making a down payment. Less stringent programs allow borrowers to have 6 months of post-closing reserves. The more important change to the self-employed loan programs involved back-up checks with the IRS. The majority of most no-income verification loan programs require borrowers to sign a permission statement at the closing giving the lender the right to obtain copies of tax returns from the IRS. Some borrowers' applications are checked against their IRS returns for omissions or discrepancies. Any discrepancies could result in criminal action if gross misrepresentations were made. Needless to say, self-employed borrowers are taking a risk if they plan to apply for a no-income verification loan and overstate their income to obtain approval. In addition, a self-employed borrower will not even be approved at all under these programs if the business is less than two years old. Enter one helpful program: "No-Doc Loans." Any borrower with good credit, whether self-employed or not, can simply apply for a loan with a high enough credit score and enough equity. No income verification is required. In addition, no business needs to be analyzed and no IRS forms must be completed. In fact, the borrower need not even own or operate a business. Only assets required for the down payment and closing costs must be verified. (On some programs, even asset documentation is waived). Finally, an appraisal must be performed on the property. Unfortunately, since the credit crisis of 2007 the rates on these programs have increased substantially as compared with standard full income verification fixed rates. Most lenders only offer portfolio adjustable rate loans such as 5/1 and 7/1 programs. Self-employed borrowers can take these loans out to buy the home they want now, then refinance when their improved financial records enable them to switch to a lower-rate, full documentation loan. Self-employed home buyers must
be careful not to overburden themselves with mortgage debt. Without
an underwriter to put a maximum loan amount for the borrower,
it is up to the consumer to exercise self-restraint. Michael Licamele is the Editor of MortgageAlmanac.com and President of Residential Finance Network at rfnc.com. |
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