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   ARTICLE   |   From Scotsman Guide Residential Edition   |   January 2016

Say ‘Yes’ To Small-Business Owners

When big banks turn away self-employed borrowers, mortgage loan originators can step in

Say ‘Yes’ To Small-Business Owners

For big banks, small-business owners can be tricky. Their income may be difficult to verify by standard methods. Their credit scores may be lower than other borrowers. In all, despite potentially high incomes, many banks view these prospective homebuyers as risky bets.

Because of those issues, when these small-business owners are looking for mortgages, many big banks will be quick to tell them, “no.” Mortgage loan originators can take advantage in these situations, finding alternative ways to get these borrowers qualified, turning that “no” into a “yes” — and turning a big bank’s castaway into another closed loan.

Small business is an economic engine that powers roughly two-thirds of job creation in the United States. So why is it often so tough for small-business owners to borrow from large banks? The answer can be summed up in one word: misunderstanding.

During the global financial meltdown of the late 2000s, “risky mortgages” became the common catchphrase in any discussion of blame for the nation’s economic ills. Although these mortgages certainly played a role, a slew of contributing factors were often diminished or overlooked altogether, because it is easier and safer to simply state: “It was a subprime issue.”

Suddenly, subprime mortgages were thrown overboard. Angry mobs threw the baby out with the bath-water. All the good — and there was plenty of good — was hastily discarded with the well-publicized bad.

Loans involving rational loan-to-value ratios, significant liquid asset reserves and good credit profiles no longer had a home because of the excessive debt-to-income ratios established for self-employed borrowers who could not prove their income. A model designed specifically for W-2 (or hourly) employees did not work for many self-employed entrepreneurs. It seemed as if brain surgeons had an easier time operating than finding a loan.

Income issues

Self-employed individuals take advantage of many legal business deductions so that they don’t overcompensate Uncle Sam at tax time. Among the possible deductions for a business owner are meals, entertainment, Internet, phones, automobile expenses, home offices, interest on business loans and more — provided that these expenses are deployed in the context of that owner’s business.

Consider these steps that could happen on a typical Friday night:

  • Finish work at your home office after funding one last loan for the week;
  • Call a client;
  • Research restaurants and movie showtimes online;
  • Drive to dinner, where you also will discuss loan products for self-employed borrowers.

Following all IRS requirements, a self- employed individual could legally make deductions for home office, phone, Internet, dinner and dessert all in the course of a simple night out. The employee compensated via a W-2 could not take these tax deductions.

At the end of the year, all else being equal, however, a self-employed individual will have a lower adjusted gross income than a W-2 employee and will qualify for a substantially smaller loan.

Credit concerns

The average household income for self- employed mortgage applicants is 80 percent higher than that of individuals who are not self-employed, according to Zillow. But despite those higher incomes, self-employed borrowers often have lower-than-average credit scores. Although the average FICO credit score was 695 this past April, a 2015 study by Biz2Credit found that, for business owners, the average credit score was only 600-615. That difference can lead to a significantly higher cost of debt for small-business owners over the course of their lifetimes.

The primary reason for those lower credit scores is not that small-business owners are making late payments on their debts. Instead, these entrepreneurs act in a manner that maximizes their returns, which often requires short-term capital that they can access via their business credit cards. Frequently these credit card balances are reported on their personal credit reports, raising their utilization rates and hammering down their credit scores.

The imperfect credit scoring models are not designed to remove “business” credit from “personal” credit. The result of this commingled system is small-business owners with artificially low credit scores that are not accurate predictors of loan repayment.

Regulatory woes

Large banks have myriad regulators, such as the Office of Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Consumer Financial Protection Bureau (CFPB). With each of these organizations, a major effort has been underway since the July 2010 passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act to rein in mortgage home lending.

It is challenging to address a key concern of Dodd-Frank known as ability to repay (ATR). Simply put, all residential mortgage loans made to owner-occupants must demonstrate the capacity to repay under ATR. This is exceptionally difficult for self-employed borrowers, but the task grows when adding regulations that don’t fit the self-employed business owner in a reasonable manner. The net result is: Many times, large banks simply do not incur the risk and close their lending doors for good home loans for self-employed borrowers.

These factors leave large banks in a situation where they generally cannot consider self-employed borrowers’ true income. The mere mention of regulatory concerns can send chills through bankers’ spines when they consider the possible scrutiny. This leads to mispriced personal home loans or no financing options at all for self-employed borrowers. This misunderstanding of the true credit picture intimates that large banks are not interested in small-business owners.

Help from originators

Obviously, large banks don’t really hate small-business owners. For the foreseeable future, however, they simply aren’t structured properly in the current regulatory climate to extend owner-occupied residential mortgages that are ATR compliant. On the other hand, mortgage loan originators have access to products and capital specifically designed for self-employed borrowers. For all of the listed challenges faced by big banks, originators have solutions.

Business owners understand they belong to the Fraternal Order of Difficult to Finance. They have heard “no” so many times from banks that most erroneously believe loan products for their fraternity simply do not exist — and therefore, many don’t waste their time searching. When dealing with business owners, it is necessary to quickly quash these feelings with accurate product information.

Income qualification is a starting point for a loan application. Analyze the business owner’s tax returns, but understand these returns frequently do not reflect true income. You must be prepared to seamlessly pivot to alternative-income documentation that is designed specifically for self-employed borrowers — namely, bank statements.

Mortgage Originators must ask probing questions that will lead them down the right path:

  • Do you have a personal bank account that indicates consistent deposits for the previous 24 months?; Or
  • Does your business bank account have consistent deposits for the previous 24 months?

Many small-business owners have substantial cash flow that runs through their business bank accounts. Even with business- expense deductions, the deposits substantiate an income level that meets debt-to-income ratio requirements.

Business owners frequently have signifi- cant liquid assets but cannot document income even through a bank-statement program. As a rule of thumb, if the liquid assets are greater than the loan amount, there is a home for this loan. This is provided for under Dodd-Frank and CFPB guidance. If you can document the ability to pay off your mortgage from liquid assets (known as ATR in full) without economic duress to your lifestyle, there is a loan for you.

Become an expert

Even if you solve the issue of income documentation, many small-business owners require credit advice. In many cases, tweaks made to their credit will significantly improve their scores. If a business owner has high revolving-debt-utilization rates but has significant liquid assets, paying down these debts to less than 30 percent of the available limit — even better, less than 10 percent — may result in a dramatic score increase.

Business owners who are motivated to obtain home financing may also consider settling collections and charge-offs to raise their credit scores. As a credit expert, however, you should advise them to only settle these debts if they have an executed agreement with creditors explicitly stating the settlement of the debt will result in the deletion of the trade line. Depending on the scoring formula, settling debts can lower a credit score because it will update that negative account’s date of last activity.

The most important component of a credit score, of course, is timely payment. Small changes in credit, however, often result in significant increases in scores and can change many loans from failed to funded.

Enjoy the relationship

Every time customers seek a banking solution — including residential mortgages — outside of their bank, the banks risk losing their relationship with those customers. This can keep bankers awake at night.

As a mortgage originator, you have no interest in other components of a banking relationship, so you are not a risk to the banks. In fact, banks have the added benefit of strengthening their customer relationships because, instead of denying their customers and providing no guidance, they are now part of the solution — even if all they did was refer their mortgage-seeking customers to you.

If you invest the resources to educate and partner with banks, they will be loyal and consistent referral sources.

•  •  •

It is evident that the residential lending market is not designed with small-business owners in mind. This market irregularity presents an area of opportunity for mortgage originators. As an added benefit, many originators are independent contractors or self-employed, making it likely they can better understand what their self-employed borrowers are going through, helping them to build strong bonds with that clientele.

With an in-depth knowledge of wholesale lender products specifically tailored to small-business owners, basic credit education and by partnering with banks, originators possess all the ingredients necessary to experience a windfall of success. Reach out to the small-business community, and all parties will be rewarded. 


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