“I’m Having My Best Year Ever; Why Don’t I Qualify?” “What Are My Options?”

The title of this blog is a lament we hear all too often from self-employed borrowers, and last week was no exception, as we received an email that said exactly that.

MOST RECENT TWO YEARS OF TAX RETURNS TO QUALIFY

Most readers know that lenders usually use the last two years of tax returns to qualify self-employed borrowers.

So if the previous two years of returns do not show sufficient income, the current “boom year” is irrelevant until tax returns can be filed to formally reflect the income.

And the soonest most borrowers can file tax returns is in January of the following year.

DILEMMAS

Self-employed borrowers often face several major dilemmas.

1. If they show more income, they pay more income taxes. Self-employed borrowers often have the ability to shelter a lot of income in order to avoid paying income taxes. So, they are often forced to bite the bullet and show more income and pay more taxes – just to qualify. To avoid the risk of paying more taxes but still not qualifying, borrowers might want to share their preliminary tax returns with their lender to see if the additional income is enough to qualify.

2. Growth results in too little income. This seems counterintuitive to many people but it was lesson #1 back in my commercial banking days at Wells Fargo. When businesses are in growth mode, they take on additional expenses that decrease profits in the current year but often don’t result in additional profits until the following year or years. As a result, many borrowers with growing and successful businesses go years without showing sufficient income to qualify. This was the case with the borrower who emailed us last week.

RECENT BAD YEAR/COVID TOO

If a self-employed borrower’s most recent year was worse than previous years, lenders will often not average the last two years but instead correlate solely to the most recent year. If the recent year was bad because of COVID, self-employed borrowers will have to jump through all kinds of additional hoops (CPA letters, additional scrutiny) to prove their business remains viable.

ONE YEAR OF TAX RETURNS

Conforming loan guidelines allow self-employed borrowers to only provide one year of tax returns to qualify on occasion. But this is never allowed for FHA or Jumbo financing, and it only works for conforming loans when borrowers are relatively strong from a credit and asset perspective.

OPTIONS = TEMPORARY NON-QM LOAN

Self-employed borrowers have several options when they don’t qualify for conventional or FHA financing.

1. Temporary Non-QM Loan: Non-QM stands for non-qualifying mortgage and these tend to be much more flexible from a qualification standpoint. Borrowers can obtain non-QM loans with just bank statements (average deposits = income) or with just rental income. The drawbacks are higher rates and fees, but these loans are still far better options than “hard money,” described below. Non-QM loans, however, have no prepayment penalties and can be paid off via a refi as soon as borrowers can show sufficient income to qualify for better financing.

2. Co-Signer: Conforming and FHA borrowers can use non-occupant co-borrowers to qualify, but such borrowers have to be very strong and willing to have a mortgage on their credit report that they are 100% responsible for. Very few jumbo lenders allow for this option and the jumbo lenders that do allow for co-signers tend to charge higher rates.

3. Waiting: Borrowers can always simply wait until the following January when they can file tax returns that will reflect their current strong income.

4. Hard Money: This is also called “private money,” and is the option of last resort as the points, fees, and down payment requirements are much higher. “Points” (each point = 1% of the loan amount) range from three to six, depending on the type of loan and property; the rates are usually in the 8% to 10% range; and down payment requirements range from 25% to 35%.