People who are self-employed have more challenges when seeking financing compared to borrowers who are employed by others.
Lenders have to determine a borrower’s likely future income as part of the loan underwriting process. It’s fairly easy to determine the future income of a salaried or hourly employee; for self-employed borrowers, the process is more complex and subjective.
Generally, lenders require two years of federal tax returns from self-employed applicants. If the borrower’s business is a partnership or corporation, tax returns from the previous two years are also required. Lenders typically will average the monthly income from the previous two years and use that figure as the monthly qualifying income. Certain non-cash expenses, such as amortization, depreciation and depletion, can be added to the taxable income before the average is calculated.
The average qualifying income over 24 months for business owners who have been in “start-up” mode over the past two years or who had a “down” year will be lower. Lenders become very concerned when a “down” year is the most recent year because it may represent the start of a downward trend. Some borrowers with 20 percent or more down may be able to get financing by supplying only the previous year’s tax returns.
Most loan originators and some underwriters may not have the education, knowledge and/or experience to properly analyze the returns and effectively determine what income and losses to ignore and what non-cash expenses can be added when calculating the income. To solve this problem, lenders in the 1980’s and 1990’s developed “stated income loans” that eliminated the requirement for self-employed borrowers with a large down-payment, good cash reserves and great credit to supply tax returns; the lender would instead rely on the income that the borrower stated on his/her application.
Unfortunately over time, lenders loosened the requirements for stated income loans to a point where they allowed any borrower to use the stated income program.
Steve Setka is an exclusive buyer’s agent with Keller Williams Realty in Durango and a licensed mortgage originator. He can be reached at 903-7782 or steve@durangore.net.
