As lenders are required by regulations set forth by the Consumer Financial Protection Bureau, or CFPB, to make sure a borrower can afford the new monthly mortgage payment.
Plus a monthly installment amount for property taxes and insurance.
This amount is also added to current revolving and installment debt minimum monthly payments and compares these two amounts with gross monthly income.
The ability to repay is documented by calculating debt to income ratios.
There are two ratios to review, the first ratio- commonly referred to as the “front” ratio- is the principal and interest payment plus insurance taxes and the second ratio, or the “back,” is the front plus other monthly credit obligations. Both of these total figures are then divided by gross monthly income in order to arrive at both the front and back ratios.
Lenders will use the minimum monthly payments listed on a credit report but will also add other monthly obligations such as spousal support or child care. Other monthly expenses such as food and utilities are not in the equation. These ratios can vary based upon the term of the loan as well as the selected interest rate and it’s a pretty straightforward calculation.
Gross monthly income is documented by reviewing a borrower’s most recent pay check stubs covering 30 days as well as the two most recent W2 forms. But for the self-employed borrowers, it gets a little trickier.
Calculating Income Using Tax Returns For The Self-Employed Borrower
Loan guidelines ask that a borrower be employed receiving regular income for at least two years, one of the reasons why two years’ worth of W2 forms is required. For the self-employed borrower however, lenders take a more global approach and don’t look at just one month. Income for the self-employed can come in waves or in the form of seasonal income.
For example, a couple owns a gift shop at the mall. In the dead of summer sales are slower but as school gets back in session and the holidays get closer, sales begin to pick up speed and reach a zenith every year just before Christmas. Sales in July might be $5,000 while sales in December $25,000.
So what does a lender do?
Which month should be counted, the most recent?
Hardly. Month to month changes for any business can vary from month to month for a variety of reasons. Because a mortgage lender doesn’t have monthly pay check stubs and W2 forms the lender takes another approach and reviews federal income tax returns.
When calculating income for the self-employed borrower the annual net income is used. Someone who receives a pay check on the first and 15th of each month and a W2 form every year shows gross monthly income on the pay stub. It’s the gross amount used for debt ratio calculation, before any withholdings are taken out.
For the self-employed, business expenses are subtracted from gross income.
Some expenses are allowed to be added back such as any depreciation the business took, but other than those “add backs” it is the net income used when calculating debt ratios for the self-employed.
Conventional loans and government-backed loans such as VA, FHA and USDA programs require a lender to document a two year self-employment history as well as make a reasonable determination the income will continue well into the future, at least three years for most loan programs. A lender can make that reasonable determination by looking at not just one year of income tax returns but two.
When calculating debt ratios for the self-employed borrower a lender will add up the income over the past two years and then divide by 24 (months). Lenders want to see a consistent year over year net income amount and when doing so can also reason the business is viable and will continue to operate in the future. Using a two year average also gives a clearer picture of the business and the lender can make the determination there will be enough income each and every month to service debt obligations.
It’s the consistency from one year to the next that can lead a mortgage company to both make sure the front and back debt ratios fall into line and the business is ongoing and will continue into the future.
But sometimes that’s not always going to happen. Sometimes someone who is self-employed has a dry spell or something happens that causes the business to temporarily have a slump in income. For example, a hair stylist made $40,000 one year and $100,000 the next. Traditional loan programs would then add the two amounts together to arrive at $140,000 and get a qualifying income amount of $5,833 per month when in reality the business is doing just fine and $100,000 is a truer picture of the business but the $40,000 is driving the average income down.
If a lender just used the $100,000 amount, the qualifying income would then be $8,333, more than 40% higher than the $5,833 average. If the business owner wanted to qualify based upon $100,000 per year it would take another year of filed income tax returns. The business owner must wait another year.
But not with a mortgage program we offer. We have a special program that only requires the most recently filed federal income tax return and not two. This mortgage loan is specially designed for someone who is self-employed and a previous year’s income was lower than normal. Perhaps the business owner took an extended vacation and wrote a book. Or traveled. Or took some personal family leave time. Whatever the reason, there was a dip. An anomaly. But that scenario no longer requires waiting another year.
The One Year Solution For The Self-Employed Borrower
This is a special loan program that takes into consideration an established business can have an isolated “off year” which brings down the average income for mortgage qualifying.
We qualify based upon the most recent filed federal income tax return in such a situation and we can qualify a purchase for a primary residence, a second or vacation home as well as a non-owner occupied, or rental property and can be used for a purchase, a refinance or even a cash out refinance.
We still however verify the business has been around for at least two years and this is easily accomplished with a copy of a business license or state business licensing information. A copy of a letter from the business’ CPA can also work as verification.
This program is hybrid mortgage and is offered as a 3/1, 5/1, 7/1 and a 10/1 mortgage either as a fully amortized, 30 year term or interest only. It’s the borrower’s choice and we can finance a loan as high as $3.5 million.
Here Is A Table Showing Maximum Loan Amounts And Acceptable Loan-to-Value
| Loan Amount | LTV |
|---|---|
| Up to $1.5 million | 70% |
| $1.5 to $2.5 | 65% |
| $2.5 to $3.5 | 60% |
We can also include a second mortgage behind the first lien to arrive at a total loan balance up to 80% of the value as well and with a maximum total debt ratio of 45. Minimum credit scores are required for this loan of 720 for either a purchase or a rate and term refinance and a minimum score of 740 for either a cash out refinance or for a non-owner occupied property.
The borrower will also be asked to provide a year-to-date profit and loss statement in addition to the most recent federal income tax return.
In the situation where a self-employed borrower applied for a mortgage and was turned down due to a down, this loan program takes into consideration that an established business can have an isolated period of lower income and treat the lower amount as an anomaly and not a regular occurrence which when reviewed in this manner seems only fair.
If this is you or someone you know and have been told to wait another year before making an offer on the home you really want, you’re on the wrong loan program. We can help.
