.(AP Photo/Jenny Kane)
ASSOCIATED PRESS
(First posted in July of 2017 and updated to include news about new non-QM (Qualified Mortgage) products available to self-employed and small business mortgage consumers).
The mortgage getting adventure for self-employed borrowers is a twofold hurdle. First, the document-gathering-discovery-phase is especially rigorous and second, the evidence requirements have so many more moving parts and potential land mines.
Case in point; I have an otherwise well qualified self-employed borrower with great credit scores, plenty of down-payment and a 2-year income analysis demonstrating plenty of income to qualify. But when we came to the the liquidity test, he failed. The liquidity test measures the ratio of liquid and near-liquid assets to current liabilities (otherwise known as the Current Ratio or Working Capital Ratio). A ratio of 1 or better and all mortgage financing options are yours for the taking. But a ratio of less than 1 and you are banished from FNMA and a host of lenders that consider you financially unworthy of consideration. No appeal, you didn’t make the cut, case closed.
In case you were wondering, there is no liquidity test for all of us regular W2 income folks.
And while the document-gathering-discovery-phase for us regular W2 incomers is pretty straightforward, self-employed folks can have a much tougher challenge.
For the most part, all us W2ers need is a couple of paystubs, maybe a W2 and sometimes even a tax return and we’re good to go!
But the self-employed paper chase begins with 2 years of tax returns; personal and business, all pages, all schedules, all everything. Add in the year-to-date Profit & Loss Statement, current Balance Sheet, a letter from an accountant proclaiming that the business has been a going concern for at least 2 years, preferably in the same location, and that use of any of the moneys on deposit in the business bank accounts will not adversely affect the business as a going concern. Even a copy of your business license may be on the must have list. And underwriters have broad discretion to request all forms of supporting evidence to fortify the basic first wave of documents.
If salaries are paid as part of a self-employed buyer’s compensation, they will need to offer up paystubs and W2s just like us regular W2 folks.
Once a self-employed borrower has submitted all of their income documents, the lender analysis and review adventure begins. The income analysis is actually pretty straightforward using standard FNMA worksheets to do the income calculation and averaging. The “numbers” plug in directly from the tax returns and the results are what the results are, pretty simple.
But the results are where the adventure begins to unfold.
Is the income stable year-over-year or is it declining? If it is declining, why is it declining and what is the evidence that it will change? Why was income reported on Schedule E one year and the next year the same income from the same source is now an LLC and reported on form 1065 and K1s? Is the income reported on the Year-To-Date Profit & Loss consistent with what was reported on last year’s tax return? And then there’s always that liquidity test!
Self-employed income analysis for mortgage financing is rife with nuance. A while back I had a client who was the majority owner of a car dealership that had been in business for generations. On the surface, he was very well qualified, very successful and easily approved. He had plenty of down payment money (his own), big credit scores, more than enough income and almost no debt. He was a grade A, major league, doesn’t-get-much-better-than-this kind of a borrower.
Except for one thing; floor planning.
Now, since my borrower was the majority owner of the dealership, the dealership tax returns had to be added to the documentation and income calculation equation.
Floor planning is the short term inventory financing used to purchase all the cars out on the showroom floor and out on the lots surrounding the dealership. As cars get sold, this short term financing is paid off but whatever remains outstanding at year-end is disclosed on the balance sheet of the company tax return. Insofar as the self-employed income analysis is concerned, short-term liabilities are a dollar-for-dollar reduction in income. So according to standard underwriting guidelines, not only did my borrower not qualify for the mortgage, he had negative income!
In the end, we made this loan happen using senior underwriting brains and common sense. But without that special dispensation, the loan was a decline by standard FNMA self-employed underwriting guidelines.
Navigating the mortgage approval process for the self-employed borrower can be treacherous. The scope of the document requirements is extensive and the opportunity for GAAP (Generally Accepted Accounting Principles) land mines that can potentially torpedo an otherwise straightforward mortgage approval, are both obvious and not-so-obvious.
Depreciation, non-deductible meals & entertainment, stable & consistent income history, positive earnings trend, changes in reporting from year-to-year, liabilities payable in less than one year and on and on. The list is long and the potential pitfalls are many.
But there are new non-QM mortgage financing products designed specifically for self-employed and small business mortgage consumers. And these are not just sub-prime loans with a new name. There are credit score floors (albeit generously forgiving), down payment requirements and specific eligibility guidelines for borrower profiles that are outside the traditional underwriting box.
An Asset Qualifier option for borrowers with sufficient liquid and near liquid assets that does not require employment or income to be considered. An Investor Cash Flow option whereby qualification is determined solely based on the rent to payment ratio on the subject property, employment and income is not verified and no debt-to-income measurement is calculated. And for self-employed borrowers showing limited income on tax returns there are Bank Statement loans that measure cash flow to determine income qualification. These loans come with higher interest rates than standard income verified mortgage financing but they open the door for many potential home buyers who may have been excluded with the collapse of the sub-prime market.
So for you self-employed home buyers, be document ready and be sure to ask your prospective mortgage lender if they know what floor planning is before you ask them about rates. The answer could be the difference between home-ownership and avoidable frustration.