Business owners are said to be the backbone of the U.S. economy. But when it comes to mortgage financing, sometimes they get the short end of the stick.
It’s not uncommon for self-employed borrowers to jump through additional hoops in order to prove their business is solvent and can produce sufficient cash flow to enable adequate repayment for any new mortgage debt.
COIVD-19 has caused mortgage financing issues for several borrowers as stricter underwriting guidelines are being implemented to make sure mortgages purchased by investors are of reasonable quality.
As part of these measures, mortgage loans to self-employed borrowers will require more documentation and analyses.
Here are some of the self-employed mortgage rules to consider if you are a self-employed borrower looking to refinance or obtain a new purchase mortgage loan.
Required Self-Employed Documentation
Fannie Mae and Freddie Mac’s self-employed mortgage requirements further expand a lenders due diligence when analyzing businesses owned by self-employed borrowers.
In particular, additional emphasis has been placed to determine how long a borrower has been self-employed, the likelihood income will continue, and the determination of the business’s solvency and ability to generate recurring, stable income to the borrower that can be used for repayment purposes.
Unlike regular W-2 employed borrowers, self-employed borrowers already need to provide additional documentation so that lenders have enough to work with to calculate the income that can be used for qualification.
Expect to provide two full years of personal and business tax returns, including all schedules and worksheets. Depending on the type of business structure, you may also be required to provide two years W-2s and K-1 statements where applicable).
While less common, a current balance sheet and copies of aged receivables may be requested from more conservative lenders. Lenders may even want two months’ worth of bank statements to support operational activity and to show funds that can be used as reserves (if required).
New credit requirements resulting from COVID-19 also require self-employed business owners to provide year-to-date (YTD) profit and loss statements (P&L) for applications received on or after June 11, 2020 until further notice1.
Self-employed borrowers have two options regarding profit and loss statements.
The first option is to provide an unaudited, signed YTD P&L that covers the month preceding the application date and aged no more than 60 days prior to the note date1. This must also be accompanied by two months business account statements representing the latest two months noted on the YTD P&L provided1.
The second option is to provide an audited YTD P&L that follows the same aging requirement. However, those providing an audited P&L are not necessarily required to provide two months supporting bank statements1.
Analyzing Business Cash Flow and Liquidity
The guidance provided to lenders for self-employed mortgage applicants requires additional analysis when determining what income can be used for qualification.
New requirements detail that a lender must now review the P&L statement in addition to the business bank statements, tax returns, and other relevant documentation to establish the current level of stable monthly self-employed income1.
In most cases, where cash flows appear to be stable or increase can be averaged to determine the gross monthly qualifying figure.
However, if income has been calculated and seems to be declining, additional analysis needs to be conducted to conclude if income has stabilized or not.
The lender may look at a mon-to-month trend or use bank statements to support their rationales. Keep in mind that proceeds from the SBA Payroll Protection Plan (PPP) or other relief programs cannot be considered business assets1.
If the income has not sufficiently stabilized, the income can be deemed as ineligible for use in the mortgage application.
Lenders are also required to calculate the business liquidity ratios to be used as part of their overall rationale. Common ratios include the current and quick ratios. A ratio above 1.00 usually is an indicator the business has sufficient liquidity to distribute earnings.
While mortgage lenders may not complete a site check like some commercial lenders may require, they still complete due diligence in terms of verifying if a business is open, operating, and generating revenue.
Existing guidance already requires lenders to verify the existence of businesses a self-employed borrower may own no more than 120 days of the note date2. However, as COVID-19 has disrupted economic activity, many businesses have been impacted and have partially or completely shut down.
In response, Fannie Mae and Freddie Mac now require, as part of their self-employed mortgage requirements, lenders to take additional steps to confirm that a self-employed borrower’s business is open and operating.
Verification that the business is currently operating must be conducted within 20 business days prior to the note date and will function similarly to a verbal verification of employment required for non-self-employed applicants2.
Types of documentation to satisfy this verification include providing your lender with either evidence of current work (ex. executed contracts or invoices), current business receipts (within 10 days of the note date and should indicate payment for services performed), or evidence through a business website that the business has current activity (ex. setting appointments, providing estimates, scheduling service, etc.)2.
How to Prepare Your Application
In 2018 there were roughly 30.2 million small businesses operating in the United States, with 22 million of those small businesses being individually operating (meaning the owner was the only employee)3. Thus, millions of borrowers will be affected by these new credit requirements.
If you are a self-employed borrower there are several ways you can prepare for the additional headwinds you will face in the wake of these new self-employed mortgage requirements.
Start by gathering and consolidating all your business documentation beforehand. Speak with your accountant where applicable, so that lenders can have access to financial documents where required.
Second, be transparent about your business activity. It’s better to be upfront with your lender than to get half-way through the application process only to be denied because your business activity may have slowed or ceased all together.
Lastly, provide ample compensating factors for the lender to examine to strengthen your application. Some examples include personal asset statements verifying additional reserves for the application or even adding a co-applicant to the mortgage loan.
1 Freddie Mac Single-Family Seller/Servicer Guide. (n.d.). Retrieved July 30, 2020, from https://guide.freddiemac.com/app/guide/bulletin/2020-19?_gl=1*13wn5im*_gcl_aw*R0NMLjE1OTE3MTU2MDkuQ2owS0NRand3X2YyQlJDLUFSSXNBUDN6YXJGV2Y3TjRPaE44eEVfclJncWVBUkkxSGhHNS1OWkR1TjJLQVBTVkxhdDdSdjYweDhrNGtZSWFBaUZPRUFMd193Y0I.*_gcl_dc*R0NMLjE1OTE3MTU2MDkuQ2owS0NRand3X2YyQlJDLUFSSXNBUDN6YXJGV2Y3TjRPaE44eEVfclJncWVBUkkxSGhHNS1OWkR1TjJLQVBTVkxhdDdSdjYweDhrNGtZSWFBaUZPRUFMd193Y0I.
2 COVID-19: Temporary Credit Requirements and Appraisal Flexibilities. (n.d.). Retrieved July 30, 2020, from http://www.freddiemac.com/learn/lo/tutorials/covid_temp_processes/index.html#/lessons/y9xhdoBjanv5wnmDhAGBBLSM3HuTO48v
3 Small Business Statistics. (n.d.). Retrieved July 30, 2020, from https://www.chamberofcommerce.org/small-business-statistics/