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Self-Employed Looking for Credit… What Do Loan Originators/Underwriters Look For?

by Jimmy Moncrief on February 12, 2014 · 11 comments

  
Self-Employed Looking for Credit

So, you are self-employed and need a loan on some real estate.

What exactly do you need?

As a bank underwriter, I underwrite a lot of these kind of loans, so in this post I will share what you need to know to qualify for a loan as a self-employed borrower.

In this post I’m going to go over some very BASIC underwriting on how I analyze a self-employed person (Part I of this post) for a business loan and how mortgage underwriters analyze your business (part II of this post).

PLEASE NOTE – there have been books written about this subject, months of training materials, so if you think I’ve left something out or disagree with me, please don’t go Nazi on me in the comments.

Let’s get started!

I don’t want to put you to sleep talking about tax-returns so let’s just use a real-life example of the President of the United States of America!  This is his Schedule C of his 2008 tax return.  Note: Schedule C is a part of your individual return.  If you are the 100% owner of the LLC you can also file the companies return as a Schedule C.  This is a very common way to file a tax-return.

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First off we look at line Line 9 and 7.  This gives us a quick snap-shot of the borrower and how big his business is.  In the case-of the President’s 2008 tax return I can see that since he has 100% gross margins – this is simply a Royalty based business.

Then we look at expenses.  What expenses were non-cash like depreciation (line 13) that need to be excluded.  Also, to get a handle on his debt service we need to exclude interest expense (line 16a & 16b).

Excluding these expenses and double-checking any extra expenses in the footnotes like amortization (another non-cash expense) we now have the cash-flow of the business.

The reason 2-3 years and interim financial statements are required are because we want to see not just a one-year snap-shot of the business but what are the trends in the business?  Trends that we are looking at are revenue trends, gross margin trends, cash-flow trends, leverage trends, etc…

Below is part II on how mortgage underwriters underwrite self-employed business owners.

Self Employment – What Do You Need?

Simply put: two years being self employed for a conventional loan.

They will need two years of tax returns (2012/2013) filed with the IRS to calculate income. They’ll probably average it over 24 months if you started early in the year, and maybe ask for 2014 profit and loss.

Self Employment and Business Entities

The LLP.. is this your business… or just what you hold property in?

Do any of the mortgages show up on personal credit or are they commercial loans, or loans not in your name?

You’d also need to provide two years of Form 1065s if you own more than 25%, and throw in the k1’s for that.

Self Employment and Your Cash

A tip: if the cash you have is in the business account… I may not accept it.

I assume you need it for the business to pay your suppliers, so I’m not going to allow you to use it to buy a property and then watch your business (which is paying us back) suffer or become insolvent.

Additionally, most lenders will ask for a business license for the past two years you’ve been in business. Either that or a letter from your tax preparer/CPA certifying that you’ve filed as self employed.

What About Mortgages?

The mortgage from your LLP probably won’t show up on your credit report (or does it?). If it doesn’t, no one would ask about it.

A commercial mortgage would actually show on the 8825 of the 1065. The issue that most often comes up, however, is that most people take out residential mortgages in their name and then transfer title into the LLC for liability coverage legally.

The debt obligation is still written to their personal names and therefore shows on their credit – which alters the ability to qualify for future loans.

We actually don’t typically ask for the 8825 of the 1065 though, as most states have commercial verification websites. We do that plus a 411 listing together for our verification of self employment. Verification through a CPA obviously is also acceptable.

Additional Self Employment Loan Tips

Additionally, you might want to also have two months of clean statements (post separation) to give the lender. Otherwise you might be sourcing deposits- ie. income from clients.

Finally, if you own less than 25% it’s passive income not self employment as defined by Fannie/Freddie/FHA. Therefore, we need 2 years of form 1040 and 2012 k1 to show % ownership, but no business return.

Questions? Leave your questions or comments below and I’ll do my best to help!
Photo Credit: epSos.de

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{ 11 comments… read them below or add one }

John February 12, 2014 at 3:18 pm

Hello –

Thanks for this post. Very timely for me. Just to be certain the criteria is the same for rentals as for primary? I’m looking to purchase another rental but also have an opportunity to contract. It seems that unless I want to wait two years to invest, I should get the property before becoming self employed. Second, can you please elaborate on “you might want to also have two months of clean statements (post separation)”?

Many thanks, great information for many i would imagine.

Reply

Jimmy February 12, 2014 at 6:42 pm

John

Your jumping the gun! That was my next blog post scheduled!

As far as the clean statements – what does your cash flow look like as being completely self-employed.

Hope this helps!

Reply

Dawn Anastasi February 12, 2014 at 4:14 pm

What if you’ve been working self-employed for 3 years + a W2 job, then leave the W2 job? Does the self employed 2 year time counter start again when you leave your W2 job?

Reply

Jimmy February 12, 2014 at 6:43 pm

Nope – it does NOT count against you.

Reply

Paula Pant February 12, 2014 at 9:25 pm

What if:

Year 1 — You ran your business as a sole prioprietor (your personal name)
Year 2 — You ran your business as an LLC, with yourself as 100 percent owner (simply for the sake of limiting liability)

Would that shift in business structure count against you?

This is for non-real-estate-related self-employment (consulting work).

Reply

Jimmy February 13, 2014 at 1:44 pm

No – it would not count against you. If you are the 100% owner you probably file it as a schedule C anyway.

Reply

Kyle Doney February 13, 2014 at 11:50 am

If the first year tax return only has 1 month (December, 12) on it as self employed, will this still count as 2 years since there are 2 tax returns or must it be a full 24 months worth?

Thanks

Reply

Jimmy February 13, 2014 at 1:46 pm

Kyle

That’s going to be a tougher sell – since mortgage underwriters want 24 months of data.

Smaller community banks are going to be more flexible with you.

Reply

Kyle Doney February 14, 2014 at 10:32 am

Thanks Jimmy. One more question. Does owning two business help? The one previously mentioned has 2 tax returns, the other is newer and has only 1. Last year I was denied a loan. After I get my returns back this year I will try again.

Reply

Cory Binsfield February 15, 2014 at 1:48 pm

How do you calculate the debt coverage ratio (DCR)? I assume you simply take the loan payment plus taxes and insurance and compare to the net cash flow? Do you add special conditions ie. projected maintenance and reserves at 10% plus vacancy at 5%? or do you look at actual hard data from the investors company itself?

Next, I always shoot for a 1.25 DCR or higher and use my cash from operations as my down payment.

Are you saying I should be able to show a separate reserve account for the down payment? I’m able to slow down on improvements when I’m purchasing to build up operational cash and then go back to major improvements when the deal is done.

What’s the minimum DCR to make the loan committee warm and fuzzy?

Reply

Yolanda July 9, 2014 at 2:56 pm

Hello! Very informative post. My question is this. I am self employed and run a home based child care business. Although I have been increasing my income yearly for nearly the last 10 years, the way I file my taxes with my schedule C shows a loss. Although I own my own home with my husband, our main income is child care. We bought our home in 2007 at the very end of the mortgage crisis where we were able to secure a loan. Since 2007 we have been unable to refinance due to the face that I always claim a loss on my schedule C.
Is there any possible way to get a refinance on our mortgage in 2014? If we plan to sell and buy another home how can we qualify for a new loan with the same issue on the schedule C?
We pay all our bills, each have no problem getting rather large credit cards, and have no trouble paying our mortgage. I really wish a Cash Flow statement would work in our situation.

Thanks in advance!

Reply

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