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Self-Employed: The Purchase and Refinance Loan Guide

A Brief History in Time

Mortgage lending has made some dramatic changes over the past few years and when you include the period beginning in 2000, there have some rather wild swings regarding loan approvals.

Mortgage lenders often change lending guidelines to more accommodate consumer demand or to open up a brand new market yet these loans come and go as lenders decide to lend more or lend less. Sometimes it’s the market itself that determines which loan types survive and which do not.

If a lender introduces a particular loan program that focuses on a particular niche yet there are no takers, the lender steps back and reevaluates the program, makes some adjustments or pulls the loan program altogether.

During the run-up to the “Great Recession” lenders of all stripes began to offer a new wave of loan programs that, for a time, helped push homeownership rates to record levels.

Lenders began offering a suite of new loans that allowed borrowers with less-than-stellar credit to obtain financing as long as there was a rather large down payment to offset the risk of making a loan to those with poor credit.

Some lenders then began to relax these guidelines and require less money down. Other programs emerged that not only reduced the down payment requirement but also lowered qualifying credit scores. Soon, the emergence of “no documentation” and “stated loans” began to appear in conjunction with loans for poor credit and little down.

This toxic mix of poor credit, little down and no documentation of the borrower’s ability to repay the mortgage on time led to a financial catastrophe.

By force or by choice, such loans vanished from the marketplace as well as many of the lenders who made them. In turn, lenders made a complete 180 degree turn and for a while it seemed that no one could get a loan approved as lenders tightened their approval guidelines to make up for the sloppiness of others.

Lenders have relaxed a bit since then and over the past few years, a more “common sense” approach has returned to the lending landscape. It’s not as difficult to obtain a loan approval as it once was but there are still a few challenges that once did not exist. And those challenges are sometimes even more difficult to overcome as it relates to the self-employed borrower.

There are solutions, but understanding how lenders evaluate the self-employed borrowers today is crucial to understand how someone that is self-employed can navigate the approval process.

Are You Really Self-Employed?

For purposes of getting a mortgage loan application approved, lenders have generally accepted guidelines as to who is self-employed and who is not. Specifically, if a borrower receives W2 wages from an employer, that individual is not self-employed.

For someone that earns than 25 percent of their annual income from a business, commissions or bonuses, the self-employed moniker applies, or at least the lender evaluates an application in such a manner.

For example, there is an employee that earns a base salary of $1,500 per month but her real income is from the commissions she makes at the department store, which average $3,000 per month for a total average gross monthly income of $4,500. Since her commission income is more than 25 percent of her total, lenders treat her as a self-employed borrower, even though she receives a W2 each year and a pay check on the 1st and 15th.

Another example is someone who receives income from a partnership, LLC or corporation when the income, again, is greater than the 25 percent threshold. The most common form of self-employment is the sole proprietor, where no legal business formation is created.

The borrowers in this instance simply check the box “Self Employed” on the loan application and the loan moves forward.

To understand who is and who is not self-employed is important when calculating qualifying income used to approve mortgage loan applications. Some income can be used and some income cannot be used.

In some instances, even when there are verified deposits in a bank account, the lender cannot use that income to help qualify.

Income for those who do receive bonuses and commissions yet those amounts do not exceed 25 percent of gross income, the income may be used but must also meet a litmus test. The income must be determined to be “regular” in nature and not an isolated event. For instance, an employee received a $1,000 bonus as the “Employee of the Month.” While the income can be verified, the lender won’t count it because the likelihood of receiving a consistent Employment of the Month each and every month his highly unlikely.

self-employed pay back

The ATR- The Ability to Repay When Self-Employed

One of the changes over the past few years has been the introduction of the “Qualified Mortgage” or QM. When a mortgage loan is designated as a QM loan, the lender validates the loan meets certain criteria and when a loan does meet QM criteria, the lender is then offered certain legal protections as well as the ability to freely sell that loan in the secondary market.

One of the guidelines a QM loan must meet is verifying the borrower’s Ability to Repay, or ATR. In essence, the lender must verify the borrower’s ability to repay not only the new mortgage but also an amount that includes portions of a homeowner’s annual insurance premium and property taxes in addition to outstanding installment or revolving debt.

That makes perfect sense, does it not?

When a lender reviews a mortgage loan application the lender must document there is enough monthly income to make the necessary monthly payments, right?

But for a time, some lenders and certain loan programs didn’t require that verification for those with poor credit and little down. Today, the ATR is an important component for lenders who approve QM loans. Most mortgage loans made today fall under the QM category.

Now let’s talk about the self-employed borrower’s income compared to someone who gets a regular pay check form an employer.

Calculating Income for the Self-Employed Borrower

Lenders use the ATR guidelines based upon monthly debt and use the “gross” monthly income to arrive at that determination. That’s the income before any whit holdings are considered.

The lender adds up the gross monthly income from all borrowers who are on the loan application and compares that income to monthly credit obligations and arrive at a debt-to-income ratio.

A common debt ratio is 43 which means total monthly debt should not be greater than 43 percent of gross monthly income.

For example, a couple makes $10,000 per month and have two car payments adding up to $1,000. There are a few outstanding credit card balances with minimum monthly payments of $500 and no other debt.

According to a 43 ratio guideline, monthly debt should not be greater than $4,300. $1,500 of debt already exists leaving $2,800 for a new mortgage plus a monthly amount for an annual insurance premium and property taxes.

Now say the couple find a home for sale at $500,000 and put down 20 percent for a loan amount of $400,000. With a 30 year fixed rate at 4.00% the principal and interest payment is $1,909. If property taxes are $5,000 per year and homeowners insurance is $2,000 per year, the monthly payment is then increased by $583 for a total house payment of $2,492.

Adding the existing monthly debt of $1,500, total debt is $3,992 and the debt ratio for this couple is $3,992 divided by $10,000 = 39.9, below the 43 percent benchmark.

When conventional lenders evaluate the self-employed and using the required ATR guidelines, lenders ask for the most recent two years of federal income tax returns for the borrowers as well as the business.

These guidelines are rather strict and leave very little leeway. If a borrower cannot demonstrate two years of self-employment verified by federal tax returns, the loan cannot be approved.

At least with a traditional mortgage. At the same time, those two years must show consistent, year-over-year income.

What does that mean, exactly?

It means lenders who approve loans using this method must validate there are no major fluctuations from one year to the next and if there are, the fluctuation should be relatively minor.

Lenders use the net income from the federal tax returns over two years, divide by 24 (months) to arrive at a gross monthly income figure used to evaluate a loan application.

For example, a plumber earns $120,000 in the first year and $125,000 the second. The lender divides the $245,000 amount by 24 months and the result is $10,208. If however the income is $120,000 the first and $70,000 the second, the loan will most likely be declined due to a sharp loss income, regardless of any average.

What if the income year one is $70,000 and the second $120,000?

By dividing $190,000 by 24 months, the result is $7,916. However, the lender might want to validate why there was such a significant jump in income from year one to year two.

Was it a one-time job? Two?

That’s important to note because lenders are also required to validate a “likelihood of continuance” in order to use the additional income.

The lender now has the task to make a reasonable determination that not only is the income consistent but will it continue into the future for at least, say three years?

If annual income is boosted by an isolated, one-time job then that determination will be hard to make, at least using traditional guidelines. That’s the key with the self-employed borrower, documenting consistent income over the most recent two years as well as assuring the income will be at least as consistent for the next three years.

If the self-employed borrower cannot meet both criteria, the loan application will most likely be declined.

Cash to Close and Reserve Requirements

Lenders must not only document sufficient income to qualify but also verify the borrowers have enough funds available for the down payment, closing costs and cash reserves.

If a loan requires a down payment of 20 percent, on a $500,000 sale there needs to be at least $100,000 in funds documented from the borrower’s personal funds. In addition, third party closing costs on the loan as well as lender charges must be accounted for.

Finally, cash reserves will need to be verified.

Cash reserves are expressed as the number of months’ worth of principal and interest, taxes and insurance, or PITI. From the example earlier, the PITI was $2,492. If the loan requires 10 months of cash reserves, that’s an additional $24,920 the borrowers will need to document as their own and readily available.

If closing costs on a loan are $9,000, the down payment $100,000 and reserve requirements $24,920, the borrowers will need to provide bank or investment statements showing a total of $133,920 available.

Okay, but what if the borrowers are refinancing an existing loan and a down payment isn’t in the equation?

The lender then looks at current equity in the property by way of a property appraisal. A home with $150,000 in equity would then have enough to cover a down payment requirement plus allowing the borrowers to include closing costs in with the newly refinanced mortgage.

What cannot be included in the loan amount calculation are cash reserves, those must still be accounted for in the traditional method. Acceptable liquid accounts that meet this guideline include personal checking and savings, stock or mutual funds.

Checking accounts from a business typically cannot be used and when lenders do allow business funds a letter from a certified public accountant must state that using business funds to help close on a home purchase will not negatively affect the health of the business.

If the CPA cannot make such a determination or will not provide such a letter, those funds may not be used. If so, the loan cannot be approved.

being self-employed

Getting to “Yes”

For those who receive a regular pay check from an employer, calculating gross monthly income is much easier to accomplish compared to someone self-employed. Two years of consistent returns, the lender’s determination the income will continue into the future and acceptable debt ratios are the primary criteria when obtaining a mortgage loan.

Sufficient funds to close including those needed for a down payment, closing costs and cash reserves must be verified. And finally, good credit needs to be documented.

In today’s lending environment, good credit is validated using a credit score. Lenders will pull a credit score from each of the three credit repositories, Equifax, Experian and TransUnion. And will discard the highest and lowest score, using the middle.

If there is more than one borrower on the application, the lender will use the lower of the two middle scores.

If all these criteria are met, the borrowers should be approved. If not, the borrowers must make certain adjustments or wait until another income tax return is filed showing sufficient income, save more money for cash reserves or improve credit scores.

Yet while these guidelines cover the majority of mortgage loans made today, there are answers for the self-employed borrower who cannot meet all of these guidelines, and with competitive rates and terms as well.

Solution #1

Let’s take an example of someone with two years of self-employment but the two years of federal income tax returns show $70,000 in one year and $120,000 in the second?

When averaging this income, the gross monthly used for qualifying is $7,916. If the borrower needs $9,000 per month to qualify, this loan application would be denied.

However, with a loan program that only uses the most recent income tax return and not average the last two years, the borrower could be approved using the $120,000 annual income.

There is such a loan program and it’s offered by Loan Stream and it’s the perfect solution for a borrower who has experienced an “off” year and when the two-year income is averaged together, there isn’t enough qualifying income.

Common sense lending means rewarding the self-employed borrower with the higher income amount and discarding an isolated year when income was not so great.

This program is not designed for those with damaged credit and requires a minimum credit score of 720. The down payment requirement will be at least 30 percent depending upon the loan amount and cash reserves of anywhere from 12 to 18 months will be required.

This special loan is indeed designed for the high-net-worth individual and there are minimum net worth requirements that need to be met which can easily be documented with bank and investment statements.

The solution is called the “One Year Tax Return Program” and can be used for a purchase, refinance or a cash-out refinance on a primary home or second home. The maximum combined loan-to-value is 80 percent and the maximum loan amount $3.5 million.

Hybrid ARMS range from 3/ 1 to 10/1 and are fully amortized and there is also an “interest only” option. As a bonus, business funds can be used for cash reserves.


  • Minimum loan amount of $350,000 and maximum $3.5 million
  • Minimum credit score 720
  • No short sales or foreclosures past five years
  • No gift funds allowed
  • 12-18 months payment reserves, based upon loan amount

For someone that has been turned down by a lender that requires a thorough two-year evaluation of personal and business bank statements due to fluctuating income or simply a “down” year, this program addresses that need. But don’t discard how business funds can be used for cash reserves.

Even though it appears to be a minor benefit, most lenders will absolutely not allow business funds to be counted as reserves.

Solution #2

Called the “Bank Statement Program,” another solution for the self-employed borrower does not require federal income tax returns whatsoever.

No IRS transcripts needed.

Instead of using income from a federal income tax return, income is verified reviewing the most recent 12 months of personal and business bank accounts.

In this method, income is documented by verifying the deposits in the various accounts. The lender uses these statements to verify a healthy cash flow and document income in this fashion compared to federal returns. Bank statements will show not only income but expenses as well and the lender can calculate debt to income ratios using this method.


  • Minimum loan amount $350,000
  • Minimum credit score 720
  • No short sale or foreclosure within past five years
  • Gift funds not allowed
  • Minimum 12 months payment reserves and up to 18 months based upon loan amount

As with the previous loan solution for the self-employed, this loan can be used for a purchase, refinance or cash out refinance for a primary residence or second home with loan amounts up to $3.5 million and a maximum CLTV of 80 percent.

This loan is ideal for the self-employed borrower who returns do not show sufficient income to qualify using traditional self-employed income analysis but can document income using bank and investment statements.

These programs are designed to fulfill a lending niche that is underserved. The self-employed borrower can sometimes be difficult to approve when employing traditional underwriting guidelines when common sense says the borrowers are absolutely deserving of a mortgage.

As you might expect, there are more guidelines that can be described here but we have hit the major obstacles with proper solutions.

Over the years, lenders have made loans more difficult to qualify for and especially so for the self-employed. Yet that really shouldn’t be the case, especially when the lender has documented the borrower’s entire financial and credit profile using so-called “non-traditional” methods when evaluating high net worth borrowers with good credit.

If you or someone you know is facing such a challenge when applying for a mortgage, if the basic criteria are met for these loan programs, the self-employed borrowers can indeed be approved with competitive rates and loan terms.

You just know where to look.

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Chad Baker, CrossCountry Mortgage   
NMLS# 329451 | CCM NMLS# 3029