Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [email protected].
Question. Cathy from AZ asks: Hello Brian. I’m a self-employed shop owner in a Grand Canyon tourist town. Business has been good for the past several years and I’m feeling confident enough to finally purchase a home at the age of 37. Home prices are very affordable in this small community but not a lot of houses are for sale. I’ve been trying to get preapproved for a mortgage so that I can move fast when a house I’m interested in becomes available. Because my store has both good and not so good years, I’m not having any success being preapproved. One of the problems I have is that when income was good, I’ve reinvested in the business. I haven’t been taking a large income. Now, I’ve mostly stopped growing the business and I’m taking more income. Any ideas how I can improve my chances of being preapproved?
Answer. Hi Cathy. You are not alone with this problem. More and more people are becoming self-employed. According to the U.S. Bureau of Labor Statistics, there were 9.6 million self-employed workers in 2016 and the number is growing steadily. That’s a large enough market to attract lenders. Unfortunately, the large institutional lenders don’t have a history of serving this market well at all.
Cathy, your best option is working with a mortgage broker. Try finding one who actively works with self-employed buyers. They will have more options for you to consider. Conventional and FHA loans are available to the self-employed but these lenders insist on only using your taxable income (W-2 tax form). That’s the big problem for many self-employed who might have $9,000 in monthly revenue but after business expenses, only show $2,000 for income. That will probably mess up your debt-to-income ratio (DTI). FHA and conventional lenders usually have a maximum 43% DTI ratio.
What you are most likely looking for is a lender allowing bank statement loans rather than W-2 loans. These usually allow you to apply your full income (all deposits on your bank statements) towards the DTI ratio. You’re likely to need to show at least 1 year (probably 2) of bank statements.
You need to have your business documentation in order. Beside the bank statements, the lender will want to see your business license, a CPA letter, a profit and loss statement, and possibly letters of reference from a vendors or clients. Exactly what you need depends on the lender and your type of business.
Lenders making bank statement loans understand that small businesses have significant income fluctuations. Cathy, as you mention, you have good and not so good years. Seasonal or inconsistent income is often an issue with FHA or conventional loans. What bank statement programs do is take the average of 12 or 24 months of bank statements to average out the monthly income. This might be what you need to get a mortgage.
Cathy, take heart because the growing self-employment market is being noticed. This month, Freddie Mac announced a new All For Home program. It’s a broad program intending to provide more information and tools to help the self-employed, millennials, women, veterans, people with disabilities, senior citizens, and very low- to moderate-income borrowers obtain homeownership. A new tool specifically intended to help qualify the self-employed is the Loan Product Advisor® Asset and Income Modeler (AIM) for self-employed. Its purpose is automating a lender’s complex and time-consuming, manual income assessment process. Unfortunately, these types of national programs take a long time to roll out. Also, there is no indication that Freddie Mac is moving away from the W-2 or 1040 tax form requirements. However, your business is probably your biggest asset so you might get help from this new tool.
Probably the biggest cause of today’s tight mortgage qualifications is the Dodd-Frank Act following the Great Recession. An important clause in the law says:
“[A lender] making a residential mortgage loan shall verify amounts of income or assets that such creditor relies on to determine repayment ability, including expected income or assets, by reviewing the consumer’s Internal Revenue Service Form W–2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer’s income or assets.”
The traditional mortgage market is very conservative and insists on only tax and institutional records. However, there is the statement, “or other third-party documents that provide reasonably reliable evidence of the consumer’s income or assets.” As the marketplace changes, more lenders will become willing to rely on less than institutional paperwork. Private lenders have always operated in this area and private lenders are becoming more active helping the self-employed become homeowners. You just have to diligently look outside of the institutional mortgage market.
What are your thoughts and comments about how the self-employed can be preapproved for a mortgage? Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [email protected].
LoanBeam, the automated income calculation software behind Freddie Mac's AIM for self-employed takes complex tax return packages and calculates the income automatically. Hundreds of lenders are using LoanBeam around the US to simplify the mortgage application process for self-employed borrowers. If you are self-employed and thinking about a mortgage, ask the lender if they use LoanBeam!
Thanks you for your insight. I'm sure readers will appreciate it. I do.