This article discusses the requirements self-employed homebuyers need to meet to qualify for a mortgage, and offers advice for transaction agents to guide self-employed buyers through the qualification process.
Self-employed homebuyers, under suspicion
On the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act to re-regulate the lending industry, homebuyers and refinancers face new challenges in qualifying for a mortgage. Self-employed buyers are particularly susceptible to these obstacles under the new lending paradigm.
The reason for the extra scrutiny is due to the uncertain nature of self-employed individuals’ businesses and earnings. It’s difficult to ascertain whether a self-employed homebuyer will be able to make their mortgage payments each month when their monthly income fluctuates more regularly than that of a typical salaried employee. Therefore, self-employed buyers need to meet extra documentation requirements and jump through more procedural hurdles with the lender in order to obtain mortgage funds.
Real estate agents can sympathize, largely falling under the self-employed umbrella. Some months are more profitable than others, as sales and fee amounts are often beyond their immediate control.
The extra requirements vary based on the type of mortgage sought. Homebuyers have many mortgage options to choose from. Self-employed homebuyers can apply for:
- a conventional mortgage, including a fixed rate mortgage (FRM) and adjustable rate mortgage (ARM);
- a Federal Housing Administration (FHA)-insured mortgage; or
- a Department of Veterans Affairs (VA)-guaranteed mortgage.
Further, a self-employed homebuyer may seek seller extended carryback financing.
Ability-to-repay mortgage requirements
Ability-to-repay rules took effect in 2014. Like the name suggests, these rules require lenders to verify the homebuyer will be able to repay the mortgage. [12 Code of Federal Regulations §§1026.43 et seq.]
All residential consumer mortgages extended by a creditor fall under the ability-to-repay rules, which require basic documentation for underwriting, including the homebuyer’s:
- current income and assets;
- employment status;
- credit history;
- debt-to-income ratios (DTIs); and
- the value of the property that will secure the mortgage.
Mortgages exempt from the ability-to-repay rules include:
- non-consumer mortgages, including mortgages for investment, business or agricultural purposes, even if they are secured by a one-to-four unit residential property [12 CFR 1026.2(a)(12)];
- open-ended credit plans like home equity lines of credit (HELOCs);
- mortgages on timeshares;
- reverse mortgages;
- bridge loans; and
- construction-to-permanent mortgages with construction phases of less than 12 months. [12 CFR 1026.43(a)]
A self-employed buyer applying for any other type of residential mortgage will need to provide extra documentation required by the ability-to-repay rules.
Under these rules, an applicant who owns 25% or more of a business is considered self-employed. Their self-employed income may only be used to qualify if they have been self-employed for at least one year. Further, if they have been self-employed for more than one year but less than two years, they are to provide documentation showing at least two years of previous employment in the same line of work. [Appendix Q to 12 CFR §1026 Part D]
Self-employed buyers need to also provide a:
The lender assesses the trends shown by the self-employed buyer’s documentation. The homebuyer documentation indicates whether the buyer’s income reliably enables them to timely make their mortgage payments. For instance, if a buyer’s P&L statement for the present year exhibits a decline in income over the previous year, the lender may not approve the homebuyer for a mortgage on the terms sought.
FHA-insured mortgages are more risky for the lender as they require less strict down payments (hence, the additional mortgage insurance premium (MIP)). Thus, even more documentation is required by the lender to verify a self-employed homebuyer will be able to make their mortgage payments.
An FHA–approved direct endorsement (DE) lender processing a mortgage application submitted by a homebuyer requests or generates a standard list of documents. When the buyer is self-employed, in addition to the standard documents, the buyer will also need to submit:
- individual tax returns, signed and dated, for the most recent two years;
- for a corporation, “S” corporation or partnership (LLC), copies of federal business income tax returns for the last two years;
- a profit and loss (P&L) Balance Sheet; and
- a business credit report for a “C” corporation and “S” corporations.
The FHA requires a self-employed homebuyer applying for an FHA-insured mortgage to provide a recent P&L statement. When the most recent P&L statement was filed more than a calendar quarter previous, the self-employed homebuyer needs to file a year-to-date P&L statement. A self-employed homebuyer qualifying with income greater than the average of their past two tax returns is also required to produce an:
- audited P&L statement [See RPI Form 209-2]; or
- signed quarterly tax returns obtained from the IRS. [HUD Handbook 4000.1 (II)(A)(4)(c)(x)(C)]
Current and former members of the armed services may qualify for a VA-guaranteed mortgage, which are designed to enable qualified veterans to buy a home with zero down payment. Read all about the homebuyer and property qualifications here: VA mortgage basics.
Like other mortgage types, self-employed buyers applying for a VA-guaranteed mortgage need to meet additional documentation requirements, and the veteran self-employed buyer may undergo additional underwriting in order to qualify.
The lender needs to obtain from the self-employed buyer seeking a VA-guaranteed mortgage:
- current financial statements;
- year-to-date P&L statement [See RPI Form 209-2];
- current balance sheet [See RPI Form 209-3];
- signed and dated individual income tax returns plus applicable schedules for the last two years or longer if needed; and
- for self-employed buyers whose business is a corporation or partnership:
- copies of signed federal business income tax returns for the last two years plus applicable schedules; and
- a list of stockholders or partners with the interest each holds in the business.
In most cases, self-employed buyers need to have owned their business for at least two years to exhibit stable income. Like the regular ability-to-repay rules, if the buyer has owned their business for less than two years, they need to show related employment or specialized training prior to owning their business. If they have owned their business less than one year, they will rarely qualify for a VA-guaranteed mortgage. [VA Pamphlet 26-7 Chapter 4.2.j]
For an alternative to traditional mortgages financed by a lender, self-employed buyers may consider carryback financing, also known as:
- an installment sale;
- a credit sale;
- seller financing; and
- an owner-will-carry sale.
Most carryback sellers are exempt from ability-to-repay rules since they are not considered creditors. However, if they extend consumer credit more than five times in a calendar year, they are classified as a creditor and need to follow ability-to-repay rules. [12 CFR §1026.2(a)(17)]
Non-creditor carryback sellers do not need to follow the same rules that govern most transactions for self-employed buyers.
Still, carryback sellers need to investigate a buyer’s creditworthiness, and will require self-employed buyers to show their source of income for the same reason this information is requested from a traditional lender. This includes:
- financial statements;
- tax returns for the prior two years;
- P&L statements [See RPI Form 209-2]; and
- balance sheets. [See RPI Form 209-3]
Tips for self-employed homebuyers
The additional qualifications required for self-employed homebuyers can make it more difficult to qualify. Thus, transaction agents need to diligently track the mortgage application process to provide the best advantage to their self-employed buyers. The most common issues which preclude a buyer from obtaining the mortgage sought are:
- lacking the proper length of fully documented self-employment income;
- suffering a significant financial loss in the past two years; and
- insufficient reported income, since tax deductions taken by self-employed buyers appear to diminish their final income in the eyes of the lender.
What can you, the self-employed buyer’s agent, do to mitigate these common effects of self-employment?
First of all, find an understanding lender who is willing to go the extra mile to qualify your buyer and is highly experienced originating loans for self-employed buyers. Ask the lender up-front how they deal with self-employed buyers and gauge their response. In any case, all homebuyers are advised to shop around, applying to multiple lenders in order to receive the best terms. [See RPI Form 312]
Second, the more savings on hand, the better. Since self-employment income is unpredictable, it helps to demonstrate to the lender the buyer’s ability to keep up with mortgage payments even during their unprofitable stretches by having significant financial reserves.
Third, your self-employed buyer may need to wait out the clock. In the first year of self-employment, buyers won’t qualify for a mortgage through a traditional lender. They may seek out a seller-financed deal, if the carryback seller is willing to take on the additional risk. But in most cases, they will have to wait until at least one year and in some cases two years after becoming self-employed before being able to qualify for a mortgage.
Further, if they suffered a recent loss of income, or if they took large tax deductions in the past two tax years, they may need to wait more than two years from that loss. Alternatively, they may complete an amended tax return to remove the deductions, which will result in more taxes paid by the self-employed homebuyer.
Finally, your self-employed homebuyer may consider finding a non-self-employed co-borrower to co-sign the mortgage. If their income is sufficient, the lender may qualify your homebuyer on their income alone or in addition to their less reliable income. This is generally the only option for homebuyers seeking to qualify for a mortgage with a traditional lender within one year of becoming self-employed.
Self-employed real estate agents: what has been your experience in qualifying for a mortgage? How do you best assist your self-employed buyers? Do you have tips for other agents assisting self-employed individuals? Share your experience in the comments below!