Stated-Income

How Lenders Calculate Income for the Self-Employed

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The self-employed borrower faces a much larger obstacle when calculating income for mortgage approval than the salaried borrower. Lenders are inherently tougher on those that work for themselves. It’s likely due to the housing crisis and the numerous loans that defaulted because of the lack of income verification.

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Whatever the reason, today’s borrowers working for themselves have a few hurdles they must jump through before qualifying for a mortgage.

It’s certainly not that it’s impossible. You just have to prepare yourself for more paperwork and required documentation than others.

Using Your Tax Returns

The most important document self-employed borrowers can give lenders is their tax returns. Keep in mind, this is not just your 1040. The lender needs all schedules of your tax returns. You’ll see why below.

From your tax return, a lender will take your ‘net business income.’ This differs from the salaried employee. Lenders who are paid by an employer get to use their gross monthly income for qualifying. Here’s an example:

John works for ABC Company and gets paid a salary. His W-2s for the last 2 years show that he made $50,000 per year. His lender will use $50,000 per year or $4,167 per month for qualifying income.

If John owned his own company and claimed that his gross yearly income was $50,000, but only claimed $40,000 on his tax returns, the lender would use $40,000 per year for starters. They would add back certain expenses, such as depreciation and amortization though. Unfortunately, John would not be able to use the full $50,000 salary for qualifying.

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Lenders do not add back expenses you write off, such as cell phones, meals, travel, or vehicle expenses. They will also take a 2-year average of your self-employment income. For example, if two years ago you had $30,000 in net income and last year you had $42,000, the lender would average the 2 years to come up with $3,000 per month rather than $3,500 if the lender just used last year’s income.

Declining Income

If you have declining income, it could pose a problem for your loan as a self-employed borrower. In this case, the lender will not take a 24-month average. Instead, they will take an average of the last year. Here’s an example:

John made $70,000 two years ago. However, last year, he only made $40,000. This is a pattern of declining income. The lender will not give him the benefit of using the $70,000 income, as it will increase his average. If the business continues to decline, he could get qualified for a mortgage that he would not be able to afford.

Instead, the lender would use just the $40,000 income, using $4,000/12 = $3,333 per month as qualifying income.

So you can see the difference, if he were able to use the $70,000 income, his 2-year average income would equal $4,583.

Many lenders will not write a loan for a self-employed borrower with a history of declining income, though. You may have to shop around to find a willing lender. It also helps if you have compensating factors, such as a high credit score and low debt ratio. This helps offset the risk of your business with declining income.

Down Payment Funds and How It Affects Eligibility

One other aspect of your business income lenders will evaluate is your down payment funds and where they originate. If you can prove the funds come directly from your personal account, it may not affect your business income or chances for approval. You will, however, have to prove that the assets are completely separate from the business. In other words, it’s money you set aside through the years rather than money you recently took from the business.

If the funds do come from your business, the lender will evaluate the status of your business. They will need to see asset statements for your business to determine its worth. They will then determine if the funds you took compromise the business at all. If you took more than half of the business’ assets, it could put the business at risk. If, instead, you only took 25% of the business’ assets, it may not be as big of a deal.

Each lender looks at the situation differently, so you may have to inquire with several lenders.

The bottom line is that lenders look over self-employed income very carefully. They do not use the income you make before expenses. They can only use the net business income you claim on your taxes. They will order your tax transcript to make sure the information you provide them is the same information you gave the IRS.

It’s not impossible to get financing when you work for yourself, but it does require a little more work. A lender may even ask for proof of your experience in the industry just to judge your ability to keep the business afloat. Answering the underwriter’s questions and request quickly will give you the fastest answer when it comes to qualifying for a loan as a self-employed borrower.

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What Is a Good Expense Ratio for Self-Employed Home Buyers?

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In order to get a mortgage, you need to show that you are not a high risk to lenders. This means good credit, stable income, and a good expense ratio. What if you are self-employed though? How does this relate to you?

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Self-employed borrowers are at a bit of a disadvantage. They are automatically considered ‘high risk,’ because their income can be so erratic. The longer you are self-employed, the less risk you pose to a lender. However, you still need a high credit score, proof of stable income, and what a lender considers a good debt ratio.

Let’s look at the debt ratio further.

The Magic 43% Number

You’ll likely hear the number 43% pertaining to debt ratios quite often. That’s because it’s the magic number that allows a mortgage to be considered a Qualified Mortgage. Just what does that mean? It’s protection for the lender. It shows that the lender did its due diligence and did not give you a loan that made your total monthly debts exceed 43% of your gross monthly income.

Unfortunately, for some, that 43% is hard to hit. Luckily, not all lenders require only Qualified Mortgages. It’s not uncommon for self-employed borrowers to have a debt ratio as high as 45%, but that’s typically the maximum. It means that almost half of your income goes towards your monthly bills. That leaves only 55% of your income for daily living expenses and savings.

The Factors Other Than the Expense Ratio

Believe it or not, there are other factors lenders consider when deciding if you qualify for a self-employed mortgage. For starters, they look at the stability of your business. They look at:

  • How long you have been in business?
  • The stability of your income in that business (does it increase or decrease year over year)
  • What is your experience in the business like?

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The answers to these questions help a lender determine your income stability. Let’s say you have owned your business for 3 years. The first year you had a decent amount of income, but the year after that your income declined, and the year following that it declined again. This does not prove promising to a lender. They would much rather see increasing or at the very least, steady income to help ensure that you can afford a loan. Even with a 43% or lower expense ratio, if you have decreasing income, your chances of securing a mortgage are not very high.

Of course, lenders also look at your credit score. Your income shows how much you can afford, but your credit score shows your financial responsibility. What is your credit history like over the last 2 years? Do you have a lot of defaulted debts and late payments? If so, you prove risky to a lender. They want to see a pattern of paying bills on time and not overextending yourself financially.

Finally, lenders look at your assets. They want to know that you have another way to pay your mortgage should your income falter from your business. Let’s say you have a bad 3 months in your business. Do you have money to cover your mortgage payment set aside? Lenders call these reserves. They want to know how many months of your mortgage payment you can cover with your assets. This gives them peace of mind that you won’t default on your loan no matter what happens to your self-employed income.

It’s a Big Picture

Lenders look at all factors of your application as a big picture. They put all of the pieces together to determine your risk level. Just having a great expense ratio isn’t enough. You can have a low debt ratio and still have a low credit score and unstable income.

Instead, lenders want it all to come together. You might have a slightly higher expense ratio, but have a great credit score and steadily increasing income. If you can prove you have what it takes to survive in the industry you are in, a lender may grant an exception for your slightly higher debt ratio.

Just how high will a lender go? It depends on your situation. Again, looking at all of the factors, a lender will decide. Of course, no two lenders have the same requirements. Even two conventional or FHA lenders may have different requirements. They can add overlays onto what the program requires. One lender might not see a problem with taking a 45% debt ratio, while another may want nothing to do with it.

The key is to shop around and find the deal that works best for you. Don’t assume you need a specific expense ratio or you won’t get a loan. Make your other factors as attractive as possible. Increase your credit score, stabilize your income, and make sure your income steadily increases (not decreases). The combination of all of these factors can help you get the loan you need as a self-employed borrower.

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Alternative Ways to Demonstrate Mortgage Affordability

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Mortgage lenders are most concerned with mortgage affordability. If you can’t demonstrate that you can afford a loan the standard way, are you out of luck? If you do the right homework, you can find a lender willing to accept alternate methods of verifying your income. The bottom line is you have to verify your income in some manner. The lender has to know that you can afford the loan. But, it doesn’t always have to be the standard way.

What’s the Standard Income Verification?

A conventional or government-backed loan will require you to provide paystubs, W-2s, and/or tax returns. Without these documents, you can’t get these types of loans. They want to see at least the last months’ worth of paystubs and the last 2 years’ of W-2s. If you work for yourself or work on commission, you’ll need to supply your tax returns for the last two years.

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What if you don’t have paystubs or your tax returns don’t show the ‘true’ income you make? This is when alternative loans come into play. Subprime lenders, or lenders that keep loans in their own portfolios, accept other forms of income verification.

Showing Your Mortgage Affordability Your Way

If you don’t meet the mold of the standard income verification method, you’ll have to find another way to verify your income. Lenders must verify that every borrower can afford the loan in some way. The following are the most common ways.

Bank Statements

Bank statements are often used for the self-employed and borrower’s paid on commission. These borrowers often claim a large number of expenses on their tax returns. Because lenders use the net income reported on a borrower’s taxes, this often hurts them. Rather than using their taxes, they show their bank statements for the last 12 months.

The bank statements you use should show consistent deposits. This shows the lender that you make regular income. Of course, the income you show must be in line with the income that is standard for your industry.

Investment Statements

If you don’t work, but rather survive on your investments, you can use your investment statements to show mortgage affordability. You’ll have to prove that you make enough income from your investments to cover the mortgage payment plus all of your living expenses. Basically, the investment income takes the place of your standard income.

3rd Party Income Verification

If you are self-employed, a letter from your CPA or tax accountant may also help you get qualified for a loan. This 3rd party can confirm the amount of income you make as well as its consistency. Usually lenders will require year-to-date Profit & Loss Statement along with the CPA letter.

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What’s the Catch?

It seems too easy to qualify for a loan with alternate forms of income verification. There has to be a catch, right? There is, but it’s not horrible – you’ll just pay more in interest. Lenders base your interest rate on the riskiness of your loan. If you don’t verify your income the standard way, you are automatically riskier.

Lenders often charge more upfront on the loan as well. They may charge origination points or discount points. Origination points are points to get the loan processed and closed; it’s like an extra fee on top of the other closing costs. The discount points are points you pay to buy the interest rate down. No matter which one you pay, you pay them upfront.

Lenders use this money as instant profit. If you were to default on the loan down the road, they have the money they made upfront as a consolation prize of sorts. It’s not the ideal situation, but it helps lenders be able to write riskier loans such as these.

Today it’s a little harder to find alternative ways to prove mortgage affordability. With the Qualified Mortgage Rules along with the Ability to Repay Rule, lenders are more careful about who they lend money to. It’s always a good idea to provide compensating factors to help your case. The more stable your income and the more reserves you have on hand, the better your chances of approval. In addition, if you have a high credit score and low debt ratio, your chances of approval get even higher.

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Will Your Bonus Income Count on Your Home Loan Application?

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Money

You make bonus income, so you automatically think your total income will count for mortgage qualification. Unfortunately, you might be wrong. There are only certain circumstances that lenders will allow the use of this time of income.

We’ll review these situations for you below.

What is Bonus Income?

First, let’s look at the definition of bonus income. It’s income you receive above and beyond your regular salary. It doesn’t matter if your receive salary, hourly, or commission income. If you receive something outside of what you expected, it’s a bonus.

How Do Lenders Look at Bonus Income?

Now comes the tricky part. How do lenders look at this income? Can you just add it to your total income for the year?

Unfortunately, lenders don’t often use bonus income and you can’t just add it to your total income. If a lender uses it, they will need an average over the last 2 years, at a minimum. This is because bonuses are not consistent income. You can’t count on them like you can count on your salary or hourly income. They can go just as fast as they came without a word of warning. Lenders like to see consistency when figuring out your income and this is one instance that is not consistent at all.

Consistency is the Key

If you want a lender to use your bonus income for qualifying purposes, you must have a history of receiving it. At the very least, you’ll need 2 years of receipt of the same amount or more. If the bonus was less the second year, the lender will determine how much less. If there is more than a 20% decrease, the lender won’t count it at all.

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Again, they need consistency. Regular income is consistent. The lender can rely on it. This is what they use to calculate your debt ratio. Income that you might or might not receive every once in a while is not consistent. Lenders usually won’t use it for qualifying purposes.

However, if you have a history of receiving the bonus over several years, a lender may use it. Let’s say your employer, who you’ve been with for the last 5 years, always gives you a Christmas bonus. You receive the bonus around the same time each year and for the same amount. This last year, your employer even increased the bonus. In this case, a lender will likely allow its use.

Now, let’s say you have been with the same employer for 10 years, but this last year was the first time he gave you a bonus. There’s no consistency or history there. Most lenders won’t use this income for qualifying purposes. They may, however, use it as a compensating factor. We will discuss that below.

Bonus Income as a Compensating Factor

Sometimes borrowers are on the border of being approved and denied for a loan. Maybe their debt ratio is right on the fringe or their LTV is pretty high. A lender teeters between approving and denying the loan. As they go through the file, they see sporadic bonus income. This might help push them towards approval rather than denial. That bonus income can be seen as a way to help get the mortgage paid if the borrower has financial trouble.

You can look at is another positive factor in the loan file. Of course, it’s up to the lender’s discretion. Compensating factors are not something that Fannie Mae, the FHA, or VA governs. If a lender feels the income can help the borrower pay their loan on time, they can use it.

How Lenders Calculate Bonus Income

Another surprise you might be in for is how lenders calculate this income. You can’t just say that you got a $2,000 raise and increase your income by that amount. Instead, you’ll need to show a history of receipt of the income. The lender will then take a 24-month average of the bonuses.

Let’s say you do receive a $2,000 bonus this year. But, last year you received $1,500. The lender will average the income over 2 years. It comes out to $1,750 per year on average. The lender then divides that amount by 12 to get a monthly average. In this case, it would add $145 to your monthly income.

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Different Lenders Have Different Opinions

This doesn’t mean that every lender will use your bonus income if you receive it for 2 years. They have to be convinced that it’s a regular thing. They may quiz your employer on the income when they request the Verification of Employment. They want to get a feel for the income and why you received it. Was it a particularly good year for the company so they rewarded their employees? Maybe it was a one-time reward that won’t repeat itself.

Just like your regular income, lenders want to know any additional income will continue for the foreseeable future. If you are close to an approval, but not quite perfect, a lender may be leery of using this income. If they push you too hard, you might not be able to afford the loan in a year or two down the road.

If you have bonus income, make sure you get as much proof of it as you can. At the very least, make sure you have at least 2 years’ of income receipt. You should also make sure you have ample proof of its origination and when and if it will continue. If you get to use it, consider it a “bonus.” It might give you the edge you need to secure loan approval.

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The Real Reasons to Use an Alternative Documentation Loan

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Documents

You don’t need perfect credit or a W-2 to secure a mortgage. Alternative documentation loans allow some flexibility in qualifying for a mortgage.

Read on to see what options may be available to you.

What is an Alternative Documentation Loan?

The exact definition of an alternative documentation loan depends on the lender. There aren’t any regulations or requirements for this type of lender. It’s not your A-paper or subprime loans. It’s somewhere in between. It’s a straightforward loan with the same benefits as any other loan. The difference is in how you qualify for it.

The Characteristics of an Alt-A Loan

There are many different ways you can get an Alt-A loan. With any Alt-A loan, though, you don’t provide the same documentation as a full documentation loan. In a full doc loan, you would provide:

  • Pay stubs
  • W-2s
  • Tax returns
  • Bank statements
  • Employment verification

In an alternative documentation loan, you won’t provide all of that. You might provide some of it, though. It depends on the program.

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Instead, you’ll provide what they call “limited documentation.” Maybe you have a job that has variable income. You might qualify for the loan based on your assets alone. You’d be a good candidate for this limited documentation loan. Rather than providing W-2s and tax returns, you might just provide your bank statements.

Who Qualifies for an Alternative Documentation Loan?

Every lender has different requirements. There isn’t a blanket policy for every bank. One bank might require a credit score over 680. Another might allow scores as low as 620. It’s impossible to know unless you apply with various lenders.

The real question is who would benefit from this type of loan? Following are the most common borrowers:

  • Self-employed – These borrowers often have inconsistent income or claim a lot of expenses on their tax returns. Qualifying with full documentation probably wouldn’t occur. Even though the borrowers can afford the loan, it doesn’t look that way on paper.
  • Borrowers without a job – Some borrowers have enough assets to afford a mortgage, but don’t have employment. Without employment and a constant cash flow, it could be hard to secure a new mortgage. Alt-A mortgages can help work around this issue.
  • Borrowers with less than perfect credit –Credit history issues might prevent standard lenders from approving your loan. This might make the Alt-A loan a good solution for you. These lenders make up their own rules and can often work around issues as long as they aren’t housing related.
  • Borrowers that need a high LTV – The more you borrow, the riskier you become. FHA loans do allow LTVS up to 97.5%, but you still need straightforward income and decent credit. Combine either factor with a high LTV and you have a recipe for trouble. Alt-A loans can work around this issue.

Prepare Yourself for Higher Rates

Don’t be alarmed if you pay a higher interest rate for an alternative documentation loan. It’s the tradeoff for more flexible requirements. If you want a lender that requires perfect credit and straightforward income, you can have the low rates. If you need concessions, the lender is going to charge you for it.

This isn’t to say you’ll pay excessive interest rates. It depends on the situation. As with any other loan, shop around! Don’t settle for the first approval you receive. Make sure you comparison shop. This is especially important because you have a unique loan type. You aren’t looking for a Fannie Mae or FHA loan. Each lender will have their own program.

If you think you don’t fall under the “a paper” loans, consider alternative documentation loans. More and more lenders offer them today. As the number of self-employed borrowers increases, the need for this type of lending increases.

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Jumbo Loans Get Redefined as Conforming Loan Limits Increase in 2018

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Jumbo loans just got bigger. Beginning 2018, the conforming loan limit on a one-unit home in most parts of the U.S. will increase to $453,100 from $424,100. In high-cost counties, the standard loan limit will also increase to $679,650.

Those borrowing money higher than the standard conforming loan limits belong to the jumbo loan club. Qualifying for jumbo loans is tougher than on traditional loans because of inherent market risks and individual lender standards.

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Conforming Loan Limits Boost Jumbo Loans

The Federal Housing Finance Agency who regulates Fannie Mae and Freddie Mac has raised the conforming loan limits to reflect a 6.8% increase of home prices in the U.S. based on the seasonally-adjusted expanded-data House Price Index (HPI).

Consequently, the 2018 conforming loan limit is $453,100 and it can reach $679,650 at most to account for one-unit homes in expensive counties in the U.S.

A list of 2018 conforming loan limits is accessible here.

Fannie Mae and Freddie Mac purchase loans within those loan limits, thereby known as conforming loans. The GSE loan limits also affect other government loan programs.

For example, VA loans match GSE loan limits to calculate the amount of VA guaranty. FHA loan limits in high-cost areas are based on Fannie/Freddie loan limits.

Because jumbo loans fall outside of standards set by the GSEs and relevant government agencies, they are underwritten by individual lenders.

Qualifying for Jumbo Loans

The territory of jumbo loans is vast. These loans for bigger homes for property flippers, investors and more are offered at varying terms and conditions.

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In terms of process, applying for a jumbo loan is no different from the usual standard loan because lenders will still weigh these qualifications:

  • Credit scores on jumbo loans may be higher or at par with conforming loans. There might be some wiggle room for borrowers with less-than-perfect scores but they’ll get higher rates than those with excellent credit.
  • Debt-to-income ratio is ideally 43% and below. But ample cash reserves of at least six to 12 months can possibly make up for an above 43% DTI or a low credit score for that matter.
  • Down payments are usually higher on jumbo loans. They can be at least 10% up to 30% of the purchase price, depending on the lender.

Documenting income is tricky for self-employed borrowers taking out traditional loans. For jumbo loans, lenders might require just one year of tax returns filed with the IRS to document income from a stable or growing business.

To be fair, Fannie Mae has eased its guidelines in documenting self-employment income, requiring only one year of filed tax returns to qualify for a conforming loan.

Rates on jumbo loans are higher than on conforming loans because they carry the risk of not being eligible for purchase by Fannie Mae or Freddie Mac.

If you’re buying a home in a high-cost area, your loan might still be within conforming standards. Ask lenders about this and other loan matters.

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