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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 second major problem for the self-employed is that nearly all mortgage lenders require that borrowers be self-employed for at least two full years. For the lender, this means showing the last two years of tax returns showing two full years of self-employment income. Since most people do not start their business exactly on January 1, what this really means is that you need to be self-employed for two January to December years in order to meet the two year test.
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 the current mortgage environment, self-employed mortgage borrowers will be required to document every aspect of their business and can expect to have every part of their tax returns and business bank statements reviewed to make sure they are really making the income claimed on their tax return.
Back in 2007, “no-doc” and “no ratio” loan programs for the self-employed 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, in today’s mortgage market nearly all of those programs have been curtailed or eliminated. Still, there are a couple program available for self-employed borrowers with very good credit, lots of equity and substantial liquid reserves 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 (Yes, this is a help for co-owners of a small business – if you own less than 25% you don’t even have to read this article).
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) a letter from a CPA confirming two years of self-employment; 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.
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 2009 and $100,000 in 2010 will only be credited with an average of $75,000 in income during 2010, even if 2010 is on track to equal 2009. Some expenses can be added back to net income such as depreciation if they are non-cash expenditures. If the averaged income is sufficient to qualify, then the mortgage borrower will be approved. Another area where borrowers can add back income is for auto expenses. 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 and now some lenders require six or twelve months).
Many self-employed mortgage 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 2011, 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 mortgage borrowers become a viable alternative and make sense for lenders as well
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 (For the few remaining programs, the minimum required score for no income verification is at least 700 – Don’t even bother looking for a no income verification loan these days unless you have nearly perfect credit). On the loan application, the borrower either states what their current annual income is now or their estimate for the year. In nearly all cases, borrowers will be required to sign an IRS 4506 form authorizing the lender to check the borrower’s income, so borrowers really can’t make up their income to qualify.
Because these loans carry a higher risk, the rates are usually about 1/4% to 3% higher than normal loan rates and the down payments depend on credit score. Self-employed borrowers with 700 or higher scores, however, can now get 65% to 70% loan to value financing for purchases and refinance loans on the few remaining no income verification programs. This is a much higher down payment requirement/equity requirement than in 2008 and before, 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 borrowers for those programs where no 4506 form is required. To combat many instances of fraud encountered in the 1980’s and again in the 2000 – 2008 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 25% of their stated income in assets after making a down payment. Less stringent programs allow borrowers to have 6 to 12 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. The major downside of this program is the low loan-to-value ratios meaning that buyers need 40 to 50% down payments or refinancing home owners need to have at least 40 to 50% equity in their homes.
Unfortunately, since the credit crisis of 2007 to 2008 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 borrower to exercise self-restraint.
If you are not sure if you qualify for a mortgage after reading this article, click on one of the options below, enter your basic information and you will be put in touch with at least one mortgage loan officer who can help you determine if you qualify at no cost:
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