Real estate agents are one of the biggest groups comprising the self-employed. How will they fare under the new ability-to-repay and qualified mortgage rules?
The self-employed are facing new challenges when shopping for a mortgage thanks to the new mortgage playbook enacted by Dodd-Frank and enforced by the Consumer Financial Protection Bureau (CFPB).
The new ability-to-repay rules and qualified mortgage (QM) went into effect on January 10th, 2014. Under the new rules, lenders are required to verify all information pertaining to a borrower’s ability to repay their mortgage.
The underwriting checklist is basically what you’d expect:
- current income and assets;
- employment status;
- credit history;
- debt-to-income ratios (DTIs); and
- the value of the security (the property itself).
Under the new rules, every borrower is required to provide at least two years of personal and/or business tax returns as the basis for their ability to repay. If the lender chooses to comply with the more stringent QM rules, the borrower must also meet the new 43% DTI requirement.
Stability and continuity
There has been a lot of grumbling among lenders and mortgage professionals regarding the stringency of the QM standards. However, the self-employed face a much steeper climb to reaching the QM summit. In addition to the litany of underwriting procedures and required documents listed above, self-employed individuals are also expected to produce a balance sheet as well as a profit and loss statement (P&L). [See first tuesday Forms 209-2 and 209-3]
Two key terms in the law are “stability” and “continuity” of income — easy enough to prove for individuals with traditional employment. But independent contractors, such as real estate agents, are going to have much more difficulty proving said dependability, especially considering the “cyclical” nature of the profession (check out our recent exploration of a solution to this problem). Any inconsistencies in the information provided by consecutive yearly profit and loss statements need to be explained in detail.
Inconsistencies abound in a real estate agent’s typical tax return. Independent contractors have many methods for limiting their tax liability, which can often be messy. For instance, agents can carry over net operating losses from real estate related business activities in order to adjust their gross income. Borrowers were previously able to add these losses back to their adjusted gross income (AGI) when applying for a mortgage. Under the new rules, this activity renders the mortgage “non-qualified,” according to a specialist recently interviewed by the New York Times.
Know before you borrow
The new rules are extensive and even veteran mortgage loan originators will need some time to get up to speed. But we’ve culled some of the standout requirements for you self-employed agents to know before you apply.
Agents who have been self-employed for fewer than two years will have extraordinary difficulty obtaining a QM. Income from self-employment is considered stable and effective if the borrower has been self-employed for two or more years, according to the rules.
Lenders are also required to assess trends in the self-employed borrower’s income. If the borrower’s earnings over the past two years trend downward and the most recent tax return or P&L is less than the prior year’s tax return, the lender must use the most recent tax return or P&L.
Adjustments to income may only be added back to the AGI under the following specific circumstances:
- IRA and Keogh retirement deductions;
- early savings withdrawal penalties;
- health insurance deductions; and
- alimony payments.
Notice that carried-over net operating losses do not appear on this list.
Capital gains or losses are only considered in the event that they present a significant trend in the borrower’s income. If the borrower has a “constant turnover of assets resulting in gains or losses, the lender must determine a trend using three years’ tax returns,” according to the CFPB.
Trends resulting in gains may be added to the income. Trends resulting in losses are deducted from the income. It is interesting to note the CFPB specifically uses the example of a home flipper to illustrate the capital gains rule.
There is a lengthy section in the rule that treats the subject of rental income. Anyone who collects rents as part of their income and who is interested in applying for a mortgage in the future ought to read the rule in full (Appendix Q for qualifying standards).
Essentially, however, the rental income rules fall in the “consistency and reliability” camp. The borrower must verify a consistent rental income history by providing written lease agreements covering at least the previous two years. There ought not to be any unexplained gaps in rental income for more than three months. In other words, claiming rental income on vacation rentals may present a problem.
Non-QM, no problem
The low-doc and no-doc loans once popular with the self-employed are long gone. Of course, there are plenty of fairly priced loans available that don’t qualify as a QM, right? Not really.
Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) are in sync with the QM and accepting nary a loan that doesn’t meet the standard. Private lenders and private investors have yet to fully recover from the financial crisis and remain extremely risk averse. Although they do not have a mandate to only back and/or invest in QM, it seems they are choosing to by default.
The fact is, QM and ability-to-repay is the new mortgage paradigm. Be thankful for it as it means a more stable real estate market and thus a more stable income stream for self-employed agents. But, if you’re considering buying a home under the new market paradigm, start lining up your ducks now.