Self-Employed? Avoid These Common Borrower Traps

If there’s one type of borrower in this credit market whose profile has been scrutinized the most, it’s the sole proprietor. Self-employed individuals/sole proprietors used to be able to get stated-income loans that would allow them to provide supporting income documentation. But the paradigm has shifted, and these borrowers now have a more challenging time qualifying for a mortgage than ever before.

Financial professionals often advise the self-employed to write off as much of their expenses as possible in order to show less income on their taxes. While this is quite favorable from an accounting standpoint, taking expenses reduces the taxable income needed to offset liabilities, such as a mortgage payment.

The common self-employed borrower traps most sole proprietors will encounter when getting a mortgage include:

Not showing enough income on your Schedule C Form

Showing little income on your Schedule C reduces the amount of income you’ll have to offset your liability (new mortgage), and showing a loss (negative income) makes things even tougher. To determine the income that will be used to offset a mortgage payment (including taxes, insurance and private mortgage insurance, depending on loan program), take your combined annual income (your annual profit) for the past two years then divide by 24. The income will need to be at least 55 percent greater than the mortgage payment, assuming no other liabilities.

Not being self-employed for 2 years

This is not to say your loan will be denied if you have less than two years of self-employment history. However, you’ll need to show a net profit, with a current year-to-date profit and loss statement as well as your most recent year’s self-employed income tax returns.

Not being able to document large cash deposits

Any deposits going into your bank account have to be part of your regular income and will need to be documented as such.

Not having a third-party business validation

This means either a business license — such as a real estate license if you’re a real estate agent, for example — or a CPA letter showing that you have filed self-employed income tax returns for the past 24 months. Another option is showing your business profile online.

Using business funds in a mortgage transaction

If the funds for the transaction are coming from a business account, the mortgage lender will assess your ability to use those funds as part of your regular cash flow and business model. In other words, if your regular cash flow, income and business are such that those funds would be plausible for your use, you’ll be OK. This will be determined by the mortgage underwriter. However, if the business funds do not support a way of how those funds were originally generated, you’ll need to provide a CPA letter showing that the use of those funds does not impact the cash flow of your sole proprietorship business.

Business liabilities

Debt obligations that the business pays will show up on your credit report, so be prepared to provide supporting documentation. If these are business debts, but are paid for personally, these debts cannot be omitted, and they will count against your borrowing power.

Getting Pre-Approved

As a consumer, you’re used to being the one with the power to judge the products and services you purchase and the companies that offer them. But when it comes to financing your new home or refinancing the one you already own, you hand that power over to the mortgage lenders and, more specifically, the underwriting department.

A mortgage loan underwriter is tasked with carefully analyzing every bit of information the loan officer asks you to provide as part of the loan application process as well as the collection of “trailing documents” that you send in later to substantiate the information you’ve already provided. In general, the underwriter will attempt to verify two primary things in order to meet the bank’s criteria for offering you a loan: general creditworthiness and debt-to-income ratio.

Evaluating creditworthiness

The first thing the underwriter is concerned with is your general creditworthiness. This will give the lender an idea of your general willingness to repay your debts. There are many ways to determine this, but the most common way is to use a mortgage credit score. This score is based on an analysis of your various credit files. The most popular score is the FICO score offered by Fair Isaac Corporation, but there are others in use as well. The mortgage credit score uses consumer data stored by the three major credit repositories, Experian, TransUnion and Equifax. Income is generally not part of this calculation, but it is important, as we shall discuss shortly.

Early in the loan origination process, the lender will request your permission to pull your credit scores and then purchase a credit score as part of the underwriting process. This number is used to determine how much risk you pose and, in some cases, to match you with the right mortgage loan product. The cost of these reports is generally passed back to you at closing.

Debt-to-income ratio

The second thing the underwriter will want to know is how the new mortgage payment will impact your ability to repay. The traditional calculation for this is the debt-to-income ratio, or DTI. The DTI is a comparison of your monthly gross income (before taxes) and your monthly debts.

The debts in question include any consumer debt that would appear on your credit report, such as car loans, credit card debt and installment loans, as well as additional debt such as alimony or child support payments.  DTI requirements vary by loan program, but typically underwriters are looking to see if the ratio of debt to income — after the cost of your mortgage principal, interest, real estate taxes, insurance and private mortgage insurance (if required) are all added in — is lower than about 40 percent. Some lenders require it to be even lower.

Many other considerations go into the underwriting of a new mortgage loan, but these areas are generally where underwriters focus.