Understanding the Challenges for Self-employed Mortgage Borrowers
If you are self-employed, own a business, a sole proprietor, C-corp or any type of small business owner and have had trouble getting a home mortgage loan you need to read this.
Recently, I had several conversations with borrowers, who are self-employed, that are finding it difficult to get approved for a home mortgage loan. They told me that their banks had recently denied them. The bank couldn’t approve them for an amount they know they can afford, ran into last minute issues or was just straight-up told by their business banker that getting a loan just wasn’t possible for them right now.
As a business owner myself, I can imagine how frustrating this can be. But, you can relax, because I’m here to help you solve this problem.
Before I go into why this is such a common occurrence with self-employed borrowers and their trusted bank loan officers, let me first start with a scenario I just encountered that will help illustrate why self-employed borrowers are frequently denied. I’ll lay out for you the buyer profile, identify why they were getting denied, and share with you how I was able to help them. I did the same for 3 other borrowers in recent weeks.
For this exercise, I will use my most recent borrower who came to me looking for help with getting a mortgage. Let’s just call him Ralph.
The Scenario
Ralph came to me immediately after leaving his banker. He was just informed by that same bank, which he was a long-time business customer, that there was nothing they could do to help access any equity in his home.
Ralph knew he made enough money to borrow what he needed. The loan denial left him frustrated and confused. His business was doing well, he makes a comfortable living, uses minimal credit, and has paid off a significant amount of his mortgage.
His goal is to access the equity in his home to help his first child who is heading off to college this year. So why wasn’t the bank able to help Ralph? Let’s first start by looking at his buyer profile. This will help with demonstrating what a small business owner financial situation may look like.
Buyer Profile:
Small business owner: Roofing Contractor
Business type: S-Corp
Six (6) employees
Gross revenue: $900,000
Taxable business income: $125,000
Depreciation:
W2 income: $50,000
Ralph’s credit: 700
Wife’s credit: 605
Home worth: $300,000
Mortgage: $100,000
The Common Mistakes Made by Bank Loan Officers
Let’s take a look at the most common mistakes banks and loan officers regularly make when trying to qualify a buyer like Ralph.
Mistake #1: Taking the word of the business owner
The first mistake loan officers make when qualifying small business owners is taking their word when it comes to exactly how much money they make. This happens most frequently with sole proprietors who have a schedule C. these are your real estate agents, hairdressers, home daycare providers and other businesses where the owner is also the only income earner.
A schedule-C borrower will tell their loan officer they make $75,000 and “POOF”, a preapproval appears. What is lost in that conversation is all the items the borrower has written off for a business like their home office, mileage, travel expenses and more. These can add up to thousands or tens-of-thousands of dollars.
What happens next is that the borrower finds a home, pays for inspections and the appraisal. Then the IRS tax return comes back. Guess what? The real taxable income is only $50,000.
Remember all those deductions that weren’t asked about?
Unfortunately, 50K won’t qualify to purchase that home and the buyer has to back out feeling a little embarrassed and clueless. Ralph also knows he did not have any schedule E income, so he was not sure what his income was. He does know he gets some taxed income and then writes checks to himself every month.
Mistake #2: Incorrectly calculating the true income
The second mistake is not knowing how to properly look at a tax return and calculate the income. The good news is that if you are lucky enough to find a loan officer who requests your tax returns you are one-step ahead. The bad news is that in many cases they don’t actually know how to read them. Having personal experience of running my own business gives me insight into how to utilize tax returns.
Using Ralph as an example, let’s see what a loan officer might do to calculate income to get him the best rate and mortgage using only his credit and income.
I’ve seen the math done half a dozen ways from other loan officers and these are the results they might get.
Calculated income
Loan officer 1: $125,000 (The amount on the front of the tax return.)
Loan officer 2: $183,000
Loan officer 3: $62,500 (½ of the amount on the tax return)
Loan officer 4: $88,000
You can see there is quite a variation in the calculated income. The lowest is $62,500 while the highest is $204,000. That’s $141,500 in difference!
So, what is the correct calculation of income?
Let’s do the math and then a quick explanation below.
$125,000 (Taxable Business Income)
+26,000 (Depreciation)
+ 25,000 (179 Expense)
Total: $176,000
$176,000 X 50% = $88,000 business income that can be used!
Explanation:
First, you have to take the $125K amount from the taxable business income.
Next, loan officers need to remember to add back depreciation from the business return to the $125,000 taxable income. In this case, Ralph had $26,000 of depreciation.
But, I didn’t stop there. Take one step further reviewing the documents and I found Ralph had special write-offs on his 179 Expenses/Depreciation each year. This is Depreciation for trucks & other items that is allowed to be deducted all in one year. This one line item added $25,000 to the total income.
Often, loan officers will calculate an income of $176,000 because they fail to read the K-1 which in this case tells me that Ralph is only allowed to use 50% of the income because his wife is claiming the other 50%.
Another common miscalculation most loan officers make is that they use the $125,000 on the front of the tax return only. If they do happen to read the K-1, they would calculate Ralph to have a $62,500, forgetting to add back in the depreciation values from the business.
Mistake # 3: The Importance of Asking the Right Questions
The third mistake is not asking questions, and it’s a big one. Loan officers that don’t ask the right questions or any questions at all can really set you up for denial.
Let’s assume Ralph’s banker knew he couldn’t use Ralph’s wife’s income (poor credit). So they calculate the income of $91,500. The lowest possible calculation.
The figure increases Ralph’s DTI (Debt to Income Ratio) and resulted in him getting a big fat NO on his approval. Why? Because his bank loan officer did not ask him any questions.
Here’s is what the loan officer didn’t ask that I did. Below are my questions, responses and the reason why it is important to ask.
Question: Do you have separate personal and business bank accounts?
Ralph’s response: YES
Paying debts from your personal or business accounts will affect what can and cannot be excluded from the borrowers DTI calculations.
Question: Which car loans do you pay out of your personal account?
Ralph’s response: None, I pay them out of my business account.
Car loan payments made from a business account can be excluded from DTI calculations. However, they must be paid from that account for an entire year before they can be excluded. If they are paid for from the personal account they cannot.
Ralph’s car payment was $700/month, which adds up to $115,000 in borrower power on a 30-year mortgage.
Question: Have you co-signed for any other borrower?
Ralph’s response: YES, a car for my daughter.
Car loans and student loans where you have cosigned can be excluded from the debt calculation if Ralph can provide proof that his daughter has made the payments herself, out of her account for at least 12 months
Follow up question: Are you or her making the payments?
Ralph’s response: She is. She has been for the last 2 years.
This is important because if a co-signer has not made a payment for 1 year or more, that debt can be excluded from their DTI.
Question: Do you have any credit card expenses?
Ralph’s response: YES, I have a Lowes card for the business and pay $200 each month from the business account.
It’s important to separate the personal expenses from the business expenses to determine just how much can be excluded.
In this particular case, I was able to eliminate $1,200/month. This significantly reduced the DTI ratio of Ralph which in turn increases his chance of getting a YES on a mortgage approval. $1,200 in debts removed, allows him to borrow more for an additional total of $200,000 on a 30-year mortgage.
Mistake #4: The Limitations of Bank Loan Products for Business Owners
Ok, this one isn’t necessarily the bank loan officers fault. However, it is still a major problem when small business owners come to them in need of a mortgage.
Banks typically only offer conforming loans. These are loans that solely meet all of Fannie Mae and Freddie Mac’s guidelines. This severely limits a bank’s ability to offer solutions that meet the needs of small business owners and their borrowing needs.
If you are lucky, the bank may offer portfolio loans but those generally require as much as 25% down. That’s a hefty sum.
Mistake #5: They just don’t have the experience
Finding an experienced loan officer is tough. Yes, you will find loan officers who have been in the business for 10, 15, or 20 years but chances are they’ve spent those years working for local banks with limited products. This also limits their experience and who they are able to help. Also, they may not have specialized in just home loans.
15 years of my professional work experience has been working specifically with mortgages. What I have learned is that nearly every single borrower has a different unique situation. Getting an approval for each one is a new challenge. Luckily, as a broker, having access to multiple lenders and countless programs I have had the opportunity to work with many self-employed borrowers and lenders to learn how to best qualify them.
Don’t Give Up!
If you are a small business owner who has been denied a mortgage or haven’t even tried to get a mortgage because you heard the bank can’t do it, think again.
The key for small business owners in securing a loan is to talk to the right person with the most experience and the most available loan solutions. Generally, mortgage brokers will have more options and without a doubt have solutions that specifically fit your needs.
Brokers offer all the standard conforming loans and portfolio loans that banks offer and even have specialty loans like bank statement only loans. No need for those pesky tax returns. We even offer what’s called a CPA verification loan. These are tools we can use to get improve your chances of getting an approval.
The point is you don’t have to give up on getting a mortgage. Solutions are available and there are loan officers out there who know how to help you. Like me!
After a year behind the scenes training loan officers and trying to make sure these types of situations don’t happen to deserving, hard-working small business owners, I am starting to believe that my work is not done and I am here to help you, the self-employed borrower