The home loan process can be a challenging experience for the self employed borrower looking to purchase or refinance a home. Much of the confusion can be attributed to the calculation and documentation of income that a mortgage bank will use to determine income qualification.
The establishment of a borrower’s gross monthly income is used to calculate DTI or the “debt to income” ratio. All lenders are looking for two calculations related to debt to income ratio:
• Front End Debt to Income Ratio: Housing related expenses and cannot exceed 45% of the borrower’s gross income (Jumbo loans cannot exceed 43%)
• Back End Debt to Income Ratio: Total recurring debt obligations (house payment, car payments, student loans, credit cards, etc.) and cannot exceed 45%
It is the interpretation of income used for a home loan that can cause a challenge of the self-employed applicant. Typically, a self-employed tax payer has utilized the accounting of business expenses to offset their income tax liability. It is these deductions that lower the tax return representation of income used to qualify for a home loan. The most important thing to remember if you are self-employed is to do your research and make sure that you are working with a lender that has all options available to provide financing for a self-employed borrower.
Start with the complete documentation and move on from there
The loan process for the self-employed does not start any differently than for that of someone with a salaried position, you will be required to completed an application, a credit report will be pulled, but it will be the income documentation requirements for the self-employed borrower where the process becomes a bit more intensive then that of someone who is not self-employed:
Income Documentation for the Self Employed Borrower
A lender should always start with two years of most recent tax returns to evaluate the ability to “add back” any of the deductions to the gross income used to qualify. Most lender’s will allow certain expense deductions within the tax return to utilized as income such as depreciation, deletion, or any non- recurring items. The more complicated the tax returns, the more documentation will need to be provided
• 2-years personal tax returns with all schedules
• Two years most recent 1099s
• W2s from your self-employed business (if you pay yourself a salary)
• Federal Income Tax Schedules C, D, E, F
• 2-years business tax returns with all schedules
• K-1s
• 1120 (Corporate Tax Returns)
• 1120S (Partnerships and S Corps)
• Year to date profit and loss statement showing current income is on track with previous years
Based on the accurate analysis of income, the loan officer can make the determination of what kind of mortgage loan program will meet the needs of the self employed borrower.
- 1. Two-Year Tax Return Program (Traditional Income Analysis)
This is going to represent the most widespread income analysis of mortgage banks across the country for the self-employed borrower. Income to qualify will be determined with a two-year average of your income. This is calculated by simply adding up your income used to qualify and dividing it by 24 (months). For example; if your adjusted gross income + any expense that could be added back for was $150,000 for year one and $175,000 for year two. The gross monthly income used to calculate your debt to income ratio for your home loan qualification would be $13,541.67 per month. The traditional income analysis will provide the best mortgage terms to the self-employed borrower. It is important to start the loan process with this analysis and then move onto non-traditional home loan options for the self-employed. - Red Flags for the 2- Year Tax Return Program
If for any reason the year over year income for a self-employed borrower is more than 20% less than the previous year, the self-employed borrower could have some challenges in the underwriting process. If the income analysis indicated a decline in income it will be up to an underwriter to determine the likelihood of income moving forward. A slight decline or documentable reason for the decline (time of for the birth of a child) will more than likely be overlooked. - 2. One-Year Tax Return Programs
If for any reason, that the traditional 2-year tax return program will not facilitate the income needed to qualify, the one-year tax return program is available to the self-employed borrower. July of 2016 Fannie Mae issued new guidelines allowing the documentation of one-year tax return program for self-employed borrowers. Most lenders have access to this program however the Fannie Mae and Freddie Mac one-year tax return programs will only facilitate a loan not to exceed the conforming high-balance limit of the county where the property is based. If you are a self-employed borrower seeking a Jumbo loan amount, it is important that your loan officer have access to Jumbo 1-year tax return programs. - 3. Bank Statement Programs:
For many self-employed mortgage loan applicants, the businesses have written off so many expenses their tax returns reflect little to no income and in some situations even negative income. These are the self-employed borrowers who potentially can still purchase, or refinance a home using a bank statement analysis of income. The program will take an average of the gross deposits into a personal checking or savings account as well as the net deposit into a business account over a 12-month period time to determine income to qualify. The documentation requirement is 12 months most recent banks statements all pages and from there, the loan officer will calculate the income to qualify and proceed with the loan transaction.
Home loans for the self-employed will involve a few more steps and will be subject to a bit more scrutiny than that of an applicant who receives a standard W2 and pay-stub, but the loans are not impossible. The most important things that a self-employed borrower can do to be prepare for the loan process is to align themselves with a lender who has the experience to accurately analyze the tax returns of a self employed borrower, but also has a wide variety of programs to facilitate the lending needs of the self-employed including one-year tax return programs and bank statement programs.
