The current financial system was not designed with the self-employed in mind. The number of self-employed individuals three or four decades ago was just a tiny fraction of what it is today, and the vast majority of business processes in the financial industry were developed under the assumption the consumer was an employee with a regular, predictable income.
These circumstances have made it difficult for participants in the modern gig economy to access important financial services. One key problem is the difficulty many self-employed individuals find in getting loans, in particular mortgages.
This less-than-ideal situation for the self-employed is, however, starting to change. Financial institutions of all types are beginning to recognize that they need to adapt as the number of participants in the gig economy continues to grow. Management understands they need to improve their business processes to be more flexible, so they can provide a full range of financial services to anyone who can show they’ve got the cash flow to pay back what they borrow.
The good news is that this process has already begun. Recognition of the ongoing demographic and economic transition to the gig economy was the first step, and smaller fintech firms are leading the way with innovations in several segments of the financial industry. Larger firms have already begun snapping up these innovators or poaching talent to help develop their own products for the growing self-employed market.
Fannie Mae also revamped several underwriting/documentation rules last year, making it easier for the business owners without W-2’s to be approved for mortgages. These policy updates make it easier for three categories of self-employed borrowers to be approved for mortgages:
- Self-employed borrowers with no history of “taking paychecks” (no or irregular business distributions)
- Self-employed borrowers without two years of tax returns to support their claims
- Salaried borrowers with a second independent contractor gig for which the income is not needed to qualify
The Documentation Dilemma
Significant regulatory oversight over the mortgage industry has led to the fact that documentation is the name of the game today when it comes to qualifying for a mortgage. The documentation requirements for a mortgage can be daunting to any borrower, but the requirements are particularly burdensome for most self-employed individuals. This means that the self-employed must either jump through a veritable maze of hoops to qualify for a low-rate mortgage or pay a higher interest rate on their loan.
For the most part, down payment, debt-to-income and credit requirements are the same for W-2 borrowers and independent contractors, but the difference in documentation requirements for the self-employed is notable. Employed applicants typically only need to provide W-2 forms to prove income, whereas self-employed borrowers typically must submit two years of tax returns, including all schedules.
The tax return approach, however, often leads to problems as non W-2 filers usually write off various expenses that W-2 employees can’t. This means that their net income after all the write-offs is a lot lower than it would be without the write-offs. This makes it hard to qualify for a mortgage, because your debt-to-income ratio appears low.
Mortgage experts say the crucial factor is to demonstrate a net income, after write-offs, that results in a debt-to-income ratio in the preferred range of 36% to 43%.
If you can’t meet the preferred debt-to-income ratio, your only other options at that point is to opt for a SISA or no documentation mortgage, where you will certainly have to pay a higher interest rate.
New Research Using Multivariate Modeling Shows Self-Employed Are Not Worse Credit Risks
New research using “multivariate” modeling of credit risk (using data besides traditional income-related data) for the self-employed shows it is superior to the typical “discriminant” modeling in avoiding bad loans. This suggests lenders using multivariate assessment of credit risk can make loans to the self-employed that would be no more risky than loans to W2 borrowers.
One key reason for this is that if a W-2 employee loses her job, her income will drop to almost nothing immediately (assuming no unemployment insurance benefits), potentially creating a major risk of loan default. On the other hand, gig economy workers typically have multiple clients and are unlikely to lose all of them at once, giving them more job security than is commonly perceived.
Documenting Cash Flow Is Key to Mortgage Approval
Cash is king, and nowhere is that aphorism more apropos than the mortgage industry loan approval process.
Cash flow, not credit score, is increasingly becoming the primary consideration in mortgage credit risk assessment today. This means bank account balances, spending patterns and loan records are now as important to the process as credit reports and income tax returns.
According to financial experts, you can maximize cash flow and improve your chances at qualifying for a low-interest loan by:
- Registering and/or licensing your business.
- Paying yourself a W-2 wage (obviously this has tax implications).
- Lowering your personal or business debt load.
- Although it may sound counter-intuitive, you should consider reducing your tax deductions.
- Always maintain separate business and personal accounts.
- Making a larger down payment.
- Working with a small business where you already have a good relationship, such as a local credit union, independent bank or mortgage firm.
About the author: Brad Walker is the CEO and Co-founder of Income&, a San Francisco-based financial technology company that pioneered the PRIMO in response to America’s demand for a better fixed-income investment option.