Why Are So Many Self-Employed Home Buyers Who Are Pre-Approved For A Mortgage Later Denied?
In order to enter into a contract to purchase a home, most home buyers first receive a pre-approval letter from a lender. In a recent survey by LoanBud conducted by Pollfish, an astounding 50.29% of the 521 self-employed respondents given a pre-approval letter were later denied a mortgage by that lender.
We examine the reasons behind why so many self-employed home buyers have their application denied in underwriting, and explain how business owners, freelancers, and entrepreneurs can better protect themselves.
Lenders Don't Analyze Financial Information Until Underwriting
When someone applies for a mortgage loan, they must complete a standardized mortgage loan application. The lender will run a credit report, review the liabilities, and determine how much the applicant can qualify for based on the income provided on the loan application. At this point, most lenders are ready to issue a pre-approval letter, which one can use to enter into a legally binding contract to purchase a home. Many lenders, especially big box banks and online lenders, will not analyze the financial information that they are given by the borrower until later in the process.
This system usually works out fine for W-2 employees, who tend to have more consistent, straightforward income. If an applicant states on a loan application they make $70,000 per year with a $10,000 bonus, this normally doesn't change much when it comes time for underwriting.
A self-employed person, on the other hand, has a much more complex income structure. Self-employed home buyers typically need to provide the last two years of personal and business tax returns, year-to-date profit and loss statements, balance sheets, CPA letters, recent business bank statements, and more. If a lender bases a pre-approval letter solely on the income a self-employed home buyer entered on the mortgage application, but hasn't yet underwritten and calculated the qualifying income, it can lead to that person being later denied for the mortgage.
What Happens if Your Mortgage is Denied in Underwriting
If a mortgage is denied in underwriting, the buyer must go back to the seller and attempt to extend the contract closing date. In a hot housing market such as the one we are currently experiencing, many sellers will attempt to exit the contract, keep the earnest money deposit and find a new buyer at a higher sales price. Depending on how the contract is written, there may be a financing contingency which can allow you to cancel the contract and receive a refund of your earnest money.
Needless to say, this can be a stressful time for the home buyer because of how much is on the line. If the seller is unwilling to extend the contract, the buyer could lose out their dream home, forfeit their earnest money deposit, and have wasted time and money on appraisals and inspection fees. Not to mention, the buyer may also have their current home listed for sale or under contract, and may be contractually obligated to sell their home, which would literally leave them with nowhere to live.
If the lender was to underwrite the self-employed applicant's income up front, then this could all have been avoided. Lenders who give out pre-approval letters based on the income a borrower lists on the application face little repercussions and self-employed home buyers have little to no recourse. The lenders will simply say the pre-approval was based off the income the self-employed borrower listed on their loan application.
Typically if a self-employed home buyer is denied a mortgage, it is because of their tax returns. There are lenders such as LoanBud that will allow entrepreneurs, business owners, and freelancers to qualify using bank statements or 1099's instead of tax returns. As a self-employed borrower, it is important to understand early in the process whether or not your tax returns will qualify for the loan amount requested. The best way to protect yourself is to insist the lender underwrites your income up front, before you enter into a contract. Many lenders will not offer this as an option, or indicate a purchase contract is required to perform underwriting. At LoanBud, we underwrite every self-employed applicant's income up front so our customers have confidence knowing they will be able to close on their loan.
Online Lenders are Dangerous for Self-Employed Home Buyers
Self-employed home buyers should exercise caution when working with lenders that offer instant pre-approval letters after submitting an online mortgage application. These lenders almost never review income documentation up front which is problematic for business owners, entrepreneurs and freelancers. In this instance, the pre-approval letter is completely based on the income the applicant entered into the loan application.
Unless you are an expert on calculating your own qualifying income, which for a self-employed mortgage borrower is extremely complicated, you are better off sending your documentation to the lender for calculation. Otherwise, you are effectively being asked to determine your own income for qualifying purposes. Most people in the mortgage industry struggle to properly calculate self-employed income, so please do not try this on your own.
When it is difficult for the professionals, figuring it out on your own can be frustrating and overwhelming. If you enter the income you believe to be true into an online mortgage application, without an underwriter reviewing the financials, understand the loan may fall through at the last minute. Plus, many companies will prioritize speed over accuracy online, making things even riskier for you. Getting pre-approved for a mortgage loan in just 15 minutes can work if you are a W-2 employee, though even that can potentially be risky, however, if you are self-employed, there is no way that an online application can determine if you genuinely qualify for the mortgage in just a few minutes.
Calculating Self-Employed Income is More Difficult for Lenders
The mortgage industry is designed to look at a potential borrower's tax information to determine what their total income is. With a W-2 employee, this is easy. However, calculating the income of a self-employed person is much harder and usually requires a lot more information. Many loan officers do not understand the complexity of calculating self-employed income and lenders will often not look beyond an applicant's tax information.
Some of the information that a self-employed person needs to include in their financial information when seeking a mortgage loan include:
- Two years of personal & business bank statements
- Profit and loss statements
- Balance sheet
- Recent bank statements to support historical income levels
These documents are reviewed and analyzed to determine the qualifying income that can be used for a self-employed mortgage loan. It's important to note that lenders do not just use the "net income" from the business and personal returns. Lenders must go a step beyond and complete a cash flow analysis for the business. They are adding back items such as depreciation and depletion, but also taking away line items such as short term notes payable. Once that is done, the lender will then use a worse case income figure for qualifying. If the income is declining, there is a chance the lender will not use any income at all.
This may all seem complicated, and it is. If a business owner, entrepreneur, consultant, or freelancer is attempting to use their tax returns, otherwise known as "full documentation", it is imperative that their income is underwritten before entering into a purchase contract to buy a home.
Most Lenders Only Count Taxable Income
Most lenders require all self-employed home buyers to provide their last two years of tax returns, and will only count the taxable income after all deductions. Determining what part of your income is considered taxable by a lender can be tricky. Underwriters have a formula they use when they are determining what part of your income is qualified for your mortgage application.
The issue that many self-employed borrowers face is that they take as many tax deductions as possible, which can save a person money on their taxes. However, this lowers your taxable income and can lower your qualifying income on your application and lead to you getting a smaller mortgage loan. You may be tempted to write off fewer things in your taxes to give yourself more qualifying income, like 53.17% of our survey recipients did, but we do not recommend doing that.
Look For Lenders Who Allow Alternative Methods To Qualify Income
Many self-employed borrowers struggle to get a mortgage because of their tax returns. Some lenders, such as LoanBud, will allow freelancers, entrepreneurs, and business owners to utilize the last 12 to 24 months of bank statements or 1099's statements instead of tax returns. With an alternative documentation mortgage, the self-employed borrower is not required to provide their tax returns. This can allow more self-employed home buyers to qualify for a mortgage, regardless of business write-offs and deductions.
In a survey by LoanBud conducted by Pollfish, of the 521 self-employed respondents, 52.98% of them had trouble getting a mortgage because of their tax returns, and 62.57% said they wished there was another way for the lender to verify their income.
To qualify for a mortgage without tax returns, the borrower will need to provide evidence of their self-employment and percentage of ownership in their business, which is typically handled by a CPA letter or corporate documents.
Inconsistencies in Income Can Hurt Self-Employed
If a self-employed person's income is inconsistent and irregular, a lender is not going to count it. As a self-employed borrower, the lender will want to know the income is consistent, stable, and is not declining. If an applicant's net income showed a sharp decline from one tax filing to the next, it can potentially lead to a mortgage loan being denied. Seasoned mortgage loan officers will recognize when there is a decline in income and ask their self-employed customers to provide a detailed letter of explanation describing the circumstances. Usually, the more proactive one can be with underwriting, the better.
Typically the lender will ask for recent business bank statements to show deposits are still consistent, and a sudden decline or lack of deposits can hurt a self-employed borrower's chances. However, some industries experience ups and downs based on seasonal work. If the self-employed person can prove that this is normal for their business, they may still be able to get a mortgage loan, though they may need to provide more than two years of tax information to back up the pattern.
If there are any large deposits that are irregular, the lender will need to see why those deposits were made to ensure they are part of your business' income and why they were only made in those instances. For example, if you had a $25,000 deposit into your business account, you may be asked to prove the deposit was from business income.
Why the Mortgage Industry Needs to Change for the Self-Employed
The gig economy has been growing rapidly over the last few years. According to QuickBooks, at the end of 2019, approximately 28.2% of people were self-employed, and these numbers have been growing since the pandemic cost many people their jobs.
One of the main reasons that QuickBooks found for why more people are becoming self-employed is that W-2 jobs have seen little wage growth and being self-employed pays much more. Plus, employers have been cutting back on benefits, which also motivated people to become their own bosses. Since technology has made it easier than ever for someone to become a freelancer, we will probably be seeing even people becoming self-employed freelancers in the future. If this is indeed the case, the mortgage industry needs to re-evaluate how it handles a self-employed person who wants to seek a mortgage loan and offer more ways to prove their income than just using the W-2 alone.
While you may have heard that it is impossible to get a home loan if you are self-employed, that is not the case. There is just a little more work that needs to be done. Being your own boss, setting your own hours, and choosing to do what you love and make money from it, makes the idea of becoming self-employed alluring. If the thought that being unable to get a home loan is what is holding you back from becoming self-employed, you do not need to let that stop you.
At LoanBud, we understand that one of the cornerstones of the American Dream is to own a home, and we want to help the self-employed reach that dream. Our mortgage team is made up of experts who understand the complexities of calculating if a self-employed person qualifies for a mortgage loan. We do not give you a pre-approval until we are certain you qualify, which we determine by underwriting your financial information in the beginning. If your tax information alone is not enough to determine if you qualify, we will let you know and give you alternative ways to prove your income, like using your bank statements or 1099's for the last 12 to 24 months. You will not have to risk falling in love with your dream home only to find out later that you do not actually qualify for the mortgage amount you thought you did — or any mortgage, in some cases.
Since the mortgage industry is not built for self-employed people, LoanBud decided to create a mortgage lender that is designed specifically for the self-employed. If you are self-employed and looking for a mortgage, LoanBud is here to help you get it. Contact LoanBud today to apply for a mortgage with the self-employed mortgage experts.
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