The way a self-employed person counts his (or her) income is not the same as the way a lender calculates it. It’s not unusual for a self-employed individual to say he makes a six-figure income and then find out that only $60,000 will count. This is a blow that knocks him out of qualifying for the house he desires. But I have good news! There is now another option. I’ll explain.
Smart CPAs are hired to find all legal tax deductions. This is great when facing the IRS, but when all those deductions reduce the adjusted gross income severely, it can derail your goal to buy a home. Usually, the self-employed person finds this to be unfair and nonsensical. I can’t say I blame them, but the government sponsored agencies, Fannie Mae and Freddie Mac, have their regulations set in stone.
Another Source of Money Comes to the Rescue
Now there are lenders who will accept cash flow as an alternate way of looking at self-employed income. If the money comes into your bank account, then it counts. Expenditures are not subtracted.
Simply add up all deposits for 24 months, then take the average. That is your income on the “bank statement income program.”
Where to Get This Loan
The way to get this program for self-employed buyers is through a mortgage broker or full service mortgage lender. You will not find it at a bank or credit union. I work for a full service mortgage lender, Envoy Mortgage. I am licensed in California and Washington states. However, there are branches of Envoy in most other states, if you live elsewhere.
You want to ask the loan officer, “Do you have the bank statement program for self-employed people?”
If you have any questions, please let me know, and I’ll do my best to answer.
If you’re having difficulty getting your loan approved, you might think talking with the underwriter is a good idea. That way, you can explain your self-employment income, your tax deductions, your true rental income, your defaulted student loan, or the bad credit account.
If the loan officer gets paid only when a loan closes, why won’t she/he put you through to the underwriter? It seems logical that letting you explain things to the underwriter would be in the best interest of the loan officer as well, right?
But no. Underwriters — the final decision-makers on whether a loan is approved or denied — do not and will not speak with borrowers. Here are three reasons why.
1) The underwriter must follow the rules in the lender’s underwriting guide. These rules include exactly how to calculate income and how to handle credit. For example…
… Only 75% of rental income can be included. (25% is set aside for repairs and possible future vacancies.)
… For self-employed income, there is a complex worksheet that must be filled out. Part of that dictates that the Adjusted Gross Income is the main figure used. So if you have a clever accountant and write off tens of thousands of dollars worth of income, that lowers the income you get to count accordingly.
Therefore, you cannot call the underwriter to inform her that she has calculated your income incorrectly. Her calculations are correct and yours are wrong, according to the lender’s rules.
2) Verbal Explanations Do Not Count
If you have an explanation that needs to be included in the decision-making, put it in writing. Create a short and to-the-point Letter of Explanation that can be added to your application and loan file. Then and only then will the underwriter consider your explanation. This is because the underwriter is required to have documentation in your file to support any exception to a rule.
3) Your Loan Officer is Your Advocate
Your loan officer has a vested interest in getting your loan closed, but she/he also knows the underwriting guidelines. If a question or argument needs to be made to the underwriter, your loan officer does that for you. Thus, the loan officer serves as a gate-keeper and screen for the underwriter. Underwriters are under pressure to get loans approved and on to the Doc Draw Dept. They can’t spend half their day chatting or arguing with borrowers. It’s not in their job description. But, it is in your loan officer’s job description.
Underwriters will speak with loan officers, so if there is a valid question or argument to be made, you do that through your loan officer. That is part of what your loan officer is paid to do: be the bridge between you and everyone else in the complex process.
Remember this overriding principle: “He who holds the money makes the rules.”
If you disagree with the rules about how income is calculated or how credit is considered, that makes no difference. In Mortgage Land, the customer is not right; the underwriter is right. The underwriter must look out for the lender’s risk in lending money.
The one with the money decides on who gets it. What’s more, they don’t “owe you” to give you a loan.
Understanding this perspective will help you get approved. Ask your loan officer to explain the rules to you so you understand why the underwriter made that determination. Then, if warranted, put your explanations in a letter. Use bullet points, not long wordy sentences. A good letter can work magic. People are sometimes surprised at the loans I’ve been able to get approved by adding a succinct, logical Letter of Explanation to the loan application.
One last thing. In Mortgage Land, getting mad and yelling at people or sending upset emails does not help your cause. Underwriters do not give in because someone throws a fit. So keep your cool and your dignity, and do what needs to be done to make the underwriter happy with your application and documentation.
For self-employed people seeking a mortgage, either a purchase loan or a refinance: don’t make this common mistake!
When calculating debt-to-income ratio for the loan amount you desire, don’t use the wrong figure, or you might be in for a nasty surprise. It happens all the time…
Greg, self-employed in the construction business, reported his income to his loan officer as $95,000/year. With that, he figured he could easily qualify for a $400,000 loan. What he didn’t know was that the underwriter would subtract all the deductions he claimed with the IRS from his income. All construction materials, office expenses, wages paid out, the new truck he purchased–all deducted and all subtracted from his income. With this, his Adjusted Gross Income showed as $29,000, and that is the figure the underwriter used for qualification purposes. Much to his surprise and consternation, Greg’s request for the loan he wanted was denied.
The Adjusted Gross Income figure is the one you need to go by for self-employed income. Yes, depreciation and a few other things can be added back, but for simplicity, look at your Adjusted Gross Income.
Typically, self-employed folks hire good accountants to squeeze every legal deduction they can out of their income. That is fine. But realize you can’t have it both ways. You can’t get out of paying taxes on $95K and then turn around and claim $95K as your income when you want a mortgage.
The Take-Away here is to plan ahead. If you want to buy a house in the next year, speak with your tax preparer about making sure your income will qualify. And whatever you do, don’t go house shopping until you have a valid Pre-Approval Letter in hand that verifies the purchase price you qualify for.
Are you having trouble getting approved for a mortgage because of your self-employment? Here is a question asked by Justin on Directly.com (where I am a member):
I am an entrepreneur starting a new company (my third) and have been told by a mortgage lender that despite my successful background and ability to put 20% down, that I will have to wait two years before I can apply for a mortgage to show steady income. Are there any alternatives? I am buying in a highly sought-after neighborhood where the risk of the real estate market is considerably lower than most places in America.
My Answer For Self-Employed Home Buyers
Justin, the two-year self-employment rule comes from Fannie Mae and Freddie Mac, the two government-backed organizations (GSE) that provide money for mortgage lenders. The majority of banks and other mortgage lenders use this money; therefore, they must comply with their rules. So even if you have been making $2million/year for an entire year, are putting 35% down, and are buying in the best neighborhood in America, you will not be able to qualify for a mortgage that is backed by Fannie or Freddie money until you have a full 24 months self-employment history.
But, if you can find a lender that has their own, non-GSE money, then you have a shot at getting approved–with a good Letter of Explanation to accompany your loan application.
Another option would be to find a private seller who is willing to carry the contract (act like the bank) himself until you have the two-years. Some sellers don’t need all their cash up front and would like to make 5% to 8% on a short-term loan.
With this information, you will know what to ask right upfront. That way, you’ll save yourself and the loan officer time and emotional stress. The last thing you want to do is to apply all over the Internet, letting lender after lender, pull your credit report, because too many credit report pulls does not look good and present a red flag, in spite of the credit bureaus’ rule that multiple pulls over 30 days won’t hurt your score.