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   ARTICLE   |   From Scotsman Guide Residential Edition   |   April 2008

How to Qualify Self-Employed Borrowers

The new lending environment requires brokers and their self-employed clients to adjust their thinking

The credit crunch, which has stifled many mergers and acquisitions between big companies, is now putting the squeeze on self-employed borrowers. Many of these small-business owners rely on home-equity lines of credit to fund their operations. Others find themselves behind in adjustable-rate-mortgage payments. During financial times such as these, cash flow can quickly become a challenge.

When working with these borrowers, brokers must separate straightforward applicants from those in need of financial housekeeping. Identifying the two camps and knowing how to proceed with each will increase the chances of success for everyone involved.

For whatever reason, some self-employed borrowers take a penny-wise and pound-foolish approach to conducting their business. Patient brokers who counsel clients and balance borrowers’ immediate and long-term needs with the overall lending environment will find success.

Before attempting to help others, however, brokers must understand current market conditions and develop a way to move forward.

Taxes vs. credit

Now more than ever, brokers must counsel self-employed borrowers and impress upon them the nature of today’s lending industry.

Many loan programs have been pulled off the shelf, and tighter underwriting guidelines exist for those that remain. These developments place many self-employed borrowers in a precarious situation.

Securing the lowest-possible interest rate with the best terms now requires a large fully documented net income. That means that self-employed borrowers should expense less or find other strategies to produce a higher net income. Moreover, they also should keep federal tax records with all schedules, year-to-date income statements and all business bank statements for two to three years. Failure to do these things may result in either a higher interest rate or worse -- not having credit extended at all.

Interestingly, the advice of a tax preparer or accountant may undermine a self-employed borrower’s ability to obtain a loan when it’s needed most.


Because brokers qualify self-employed borrowers based on their net income, not their business’s gross income.

The traditional logic when dealing with the Internal Revenue Service (IRS), however, is to shield income by expensing as much as possible. Lowering taxable income produces a lower net income on tax papers. This makes sense if the business-owner’s sole concern is to pay as little tax as possible. But it only continues to make sense if the self-employed businessperson is living debt-free and has no need for the extension of credit.

The reality is that self-employed businesspeople probably have mortgage and consumer credit card debt tied to personal and business-related expenses.

Overexpensing and not reporting income is not only a serious problem for the borrower with the IRS, but this conduct also undermines borrowers when they seek credit.

Moreover, self-employed borrowers should make sure to file and pay their estimated quarterly taxes in a timely manner. Failure to comply with the law results in penalties and tax liens.

Many businesses are sole proprietorships in which personal funds are commingled with the business’s funds. This may not be a concern where legal liability and overhead are minimal.

Loan programs

The lending community generally prefers three major credit accounts with at least two years’ history in the credit file. This tends to be a good indicator of a borrower’s ability to repay obligations. Some underwriters specialize in programs that don’t require trade lines, but the cost is usually higher.

Some lenders have withdrawn their stated-income and bank-statement programs for self-employed borrowers. Cash flow is the key. In some cases, this requires the broker to do the corporate income-tax analysis to identify the net income and then take noncash expenses such as depreciation and amortization and figure them back in.

Once that is done, borrowers typically will have two years of net income averaged as the basis for qualifying. If they haven’t yet filed, an up-to-date profit-and-loss statement for the tax year will suffice with some underwriters.

In addition, generating quarterly, year-to-date profit-and-loss statements is not only a great way to benchmark the company’s financial performance, but it’s also required when submitting papers to a lender.

Moreover, while some lenders still have conforming products that allow self-employed borrowers as much as 90-percent loan to value (LTV), those programs likely will disappear soon. Portfolio investors, on the other hand, may underwrite a stated-income self-employed borrower to as much as 80-percent LTV.

Borrowers must weigh their options and decide how much risk they are willing to take. For those trying to get out of an ARM, the general sentiment is to do whatever is necessary to get into a fixed-rate loan.

Turning a blind eye to the possibility of market volatility is largely what brought us to this point to begin with. Continuing to be ignorant about changes in the lending environment and ignoring the facts will only prolong problems for some borrowers well into the future.

•  •  •

Brokers can help their self-employed borrowers better adapt to market changes by explaining loan-program guidelines. Adjusting to an unstable environment requires recognizing changes and communicating them to borrowers.

It’s also a good idea to stress the importance of cash reserves. They make a huge difference for not just households but also for small-business owners. Cash reserves are often the difference between being creditworthy and being turned down.

Brokers also may find success encouraging self-employed borrowers to consult with an attorney, tax planner, certified public accountant and financial planner. Having these people on borrowers’ advisory boards will produce a series of win-win relationships.

Remember, however, that what’s best for tax purposes isn’t always best when it comes to seeking a loan. An educated broker balances short- and long-term needs with the current lending environment.  


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