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

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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.

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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

About Author

Jimmy Moncrief is a bank underwriter and real estate investor. He blogs at RealEstateFinanceHQ.com where he talks about all things real estate. He also is the creater of free evernote templates for BiggerPockets members to learn how to better organize and automate their real estate investing.

18 Comments

  1. 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.

  2. 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?

      • Hello JIMMY me n my wife have both been working w 2 jobs and started buying houses in cash as of 2011, we today own 15 no mortgages accept 1,for 37 k under my name, I had accord 80 k refinance on 1 of 17 n 6o k refinance, just using my own credit alone when my w 2 was only 42 k a year n less then 40 k in rentals, just last year I had a depth alone of 180 k brought it down to 37 k, we bought some land cash this year and we applied for a 240 k loan to build, the bank is telling us we would not qualify and saying that my wife s 7 rentals income cant be used because she has only been w2 unemployed for little over a year,but yet she has been filling with me last 3 and most her properties are 3 years old, I do understand that last 2 years we bought like 8 house and put most of are rental cash back into the remodeling of the house,but does the bank not look that I erased 80 k n 60 k and walked out with 75k cash, which I seen about how much a person can actually hold in 2 months if they really wanted two this year we held first 6 months rent paid all our half tears taxs and insurance bought land 23 k cash took a 3k vacation and have 15 k easily stashed this year, so how is it a bank says I can not afford a 1400 a month mortgage, I been threw 3 refinances in the last three years and believe me I know the red tape involved,and all though Freddie mac n fannie may has tons of rules I do belive there is a lot of loop holes to get by is it possible my loan is very complicated, and given my w2s is almost a paperback book, that just maybe the underwriter has way to much not to deal with us and the stress,sorry my message is so long,i don’t want to jump from bank to bank and affect our scores,but we are going to reach out to the bank manger in this case and almost thinking off hiring a attorney, and with you answering dawn anastasi question about that leaving your w2 job not counting against her, why would they say my wifes has two be 2 years,
        please any feed back would be great.

  3. 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).

  4. 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

      • 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.

  5. 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?

    • Great question!

      You are correct in shooting for 1.25.

      For rental properties as a stand-alone project:

      Rent – 10% vacancy – 10-25% maintenance (depending on age of property) – taxes and insurance.

      Divide this into your debt service number and there you go with a DSCR.

      Hope this helps!

  6. 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!

  7. Jimmy,
    I find it funny you use the example of an Author for your Schedule C as my husband is an author & we don’t make even close to that sample income – I WISH!!! In fact, we are in a similar position to Yolanda (commenter) only we are trying to buy for the 1st time. Also, isn’t royalty income indicated on a different schedule E I believe? Just wondering where you came up with this example since your article is very little like what numerous mortgage brokers have told us about what income is used and added back in (you seem to skip that entirely). I know you commented earlier to not go Nazi on you in the comments but really, you don’t want anyone to call out any inaccuracies? or alternate circumstances? seriously find your example to show a real lack of reality with what most schedule C sole proprieters and authors specifically make! Daydreaming of writing a novel??? It won’t pay enough to eat your real estate investing losses. Sorry!

  8. I have a question I was working as a w2 employee for five years but quit in sept 2014 to start my own company do I still have to have self employed income for 2 years before I get a home loan

  9. I’m Tia Bond from USA. I was able to get a loan from this firm owned by Mr. Viggo Davis after i read some vital info about their loan programs online then i decided to contact them and i was funded $462,000 without much time wasted. Have you be declined for a loan from your bank or any other organization, then i will advise you to contact Mr Viggo email [[email protected]] if you are in need of any kind of loans such as: personal loans, business loans, mortgage loans and more. Contact Mr Viggo with your name, include the amount that is needed and your contact number to obtain a stress free loan. Working with them was a wonderful experience which cannot be regretted, will forever be thankful to Mr. Viggo Davis and also God almighty whom made my dreams became reality.

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