In underwriting a home loan, generally the income from a borrower who is an employee (that is paid regularly and who receives a W-2 at the end of each year), is whatever monthly income the employee is making at the time of the loan – including recent raises. Borrowers who are self-employed, however, often feel as though they are being discriminated against when it comes to qualifying for a mortgage. And rightfully so: income used to qualify for a mortgage for a self-employed borrower must be averaged over a 12 – 24 month period.
For sole proprietors, the income that is used to qualify the borrower must come from the bottom line on Schedule C of the federal tax returns. It is called “Net Profit” and is divided by 12 to come up with the monthly qualifying income. The net profit is what is left after the taxpayer deducts all of his expenses from his or her gross income. The more deductions the taxpayer claims, the lower the net profit and the lower the income tax liability; however, it also reduces the purchasing power of the borrower. Underwriters will often say, “A borrower can’t have one set of books for a loan and another set for taxes.”
Since many lenders want to average the self-employed borrower’s income over the last two years of federal tax returns, any increase in profits realized by the borrower from one year to the next is diluted when the sum of two years of net profits must be divided by 24. To top it off, when a self-employed borrower’s income drops significantly from one year to the next, it is the income on the most recent tax returns that is used to qualify the borrower and an explanation as to why their income is dropping is required.
Cash that sits in a business account of a self-employed borrower will generally not be accepted as cash that can be used to cover the down payment or closing costs for a home purchase. Generally borrowers who own 25 percent or more of a partnership, LLC, or corporation must also provide the partnership returns and/or corporate returns for two years – like a self-employed borrower.
There are, however, some programs that are better for self-employed borrowers, and that can be explained by a trained loan officer. Check with your lender!
Any lender knows that credit, collateral, and character are of the utmost importance in the lending decision. Unfortunately for many people of sterling character, in this day of automation and decision making, credit and collateral have more focus on them, and have become purely a numbers game. In fact one of the biggest issues facing homebuyers today is problems with their credit scores. Available loan products and interest rates will vary significantly with a person's credit score, and loan officers spend a fair amount of time working with borrowers to make sure that their credit score are as high as it can be.
Borrowers are told to make their mortgage payment on time and in no event later than the 30th day of the month. Even one 30 day late mortgage in a year can drop a credit score by 40-50 points and make one ineligible for certain mortgage products. Borrowers should not allow their credit card balances to go above 50% of their maximum credit limits, ideally (for credit score purposes) keeping the balances at 25% of the credit limits.
All minor medical bills should be paid once the insurance company has finalized the person’s share of the bill. Disputed charges are often less than $200, but a Collection Account on a credit report can reduce a credit score by 20-100 points.
A borrower, whether it is a purchase or a refinance, should not take out new debt during the mortgage process without speaking with their lender. This includes car loans, credit cards, etc., and also includes co-signing a loan for a friend or relative. (Co-signing, from a legal perspective, is the same as signing.) Nor should they have too many institutions run their credit report as each credit pull will reduce a credit score by about 5 points.
Many people are involved in the home loan process and lending decision, and it is in everyone’s best interest to keep credit scores as high as possible.
It goes without saying that the reason for applying for a home loan is to have it approved by the lender. But for some borrowers that is the most difficult step. Most “in the biz” agree that the lack of preparation through the pre-qualification process is the primary cause of most delays, or problems, in the loan approval process. When being pre-qualified or pre-approved, there are some common areas of questioning that borrowers should be prepared for, regardless of whether or not it is a QM or a non-QM loan: income, assets, and credit.
The first area of questions involves a borrower’s income. Is there overtime pay, commissions, self-employment income, and if so, for how many years? The basic rule on counting overtime and other income for qualifying is that it must be of a constant and continuing nature and applicant must have received for the past two years.
The second area is regarding assets: does the borrower have enough money for a down payment, closing costs, and reserves? Asset documentation, actually deposit of funds documentation is the number one stumbling block to final loan approval and closing. Generally, any deposit that is not part of employment income will need to be documented. Gift funds, sale of a car, lottery winnings, whatever - any deposit in two months of a borrower’s bank statements prior to application will need explanation and documentation.
The third area is credit. Any issues with credit are usually discovered early in the loan process when the credit report is run, at which point, if there are problems, the lender may help the borrower resolve or rehabilitate their credit.
Every loan is different because every borrower is different and brings their own set of issues to the process. The three main components of mortgage approval for an applicant are income, credit and cash, one of the three is usually the limiting aspect of how much a borrower can qualify to purchase. Knowing what the potential problems and weaknesses are in qualifying are key to a successful and smooth loan process.
Mortgage rates continue to be low – hovering around 3% to 4% for a 30-yr fixed rate mortgage – and borrowers have a renewed interest in seeing if they can refinance. Borrowers across the nation are wondering if it is the right time to buy a home or refinance. Before you apply, be sure you do your homework to ensure it makes sense financially, and to see if you’re actually able to do it. In many areas home prices have fallen and mortgage underwriting has become a lot more stringent, making it especially difficult to get approved for a mortgage.
If your current rate is in the 4% range for a 30-yr fixed rate loan, it may make sense to obtain a 15-yr mortgage in the 3% or lower area. This is especially true if you plan to stay in your home for the long haul. The cost of refinancing has gone up, so spreading this expense over a number of years can make sense – but usually not for someone who is only going to keep their home for a short period. Ask your lender to run the numbers.
Assuming you do decide to refinance, check your credit scores long before you begin the process. If your credit scores aren’t in great shape, you may not be able to qualify. But if your scores are looking good, try your best not to apply for credit cards or any other type of loan, or making big charges on existing lines of credit, as events like that have a negative impact on your credit profile. You should also check your property value. Without equity (the house being worth more than the loans on it) it will be nearly impossible to refinance unless you’re able to take advantage of one of the government programs or bring cash in at closing (cash in refinance).
Other things to keep in mind prior to refinancing are, “Is your property listed for sale?” (It should not be.) Is there a prepayment penalty on your current mortgage? There are other considerations, but give your lender a call – they can help.
Our borrowers will often ask their agent, “Are mortgage points good or bad?” For starters, let’s define “points,” as they are often misunderstood. A mortgage point is defined as a percentage of the loan amount, so if you take out a $150,000 mortgage, one (1) mortgage point would be $1,500. That is pretty simple, but there are different definitions of a mortgage point, as both mortgage discount points and loan origination fees are often thrown under the same umbrella and they are not the same nor treated equally.
A mortgage “discount point” is pre-paid interest included in closing costs that lowers your mortgage rate. This occurs when you buy down your interest rate. A loan origination fee is a fee that covers certain closing costs and the loan officer’s commission.
With that in mind, the fewer points you pay the better, right? Not necessarily - if you pay less at closing and more over the life of the loan thanks to a higher mortgage rate, you’re not paying less. Our agents will tell our clients that for those who plan to stay in their home for the long-haul and pay off the mortgage, paying mortgage discount points could be considered a good move. Conversely, if our borrowers plan to stay in their home for just a short period, or think they’ll refinance again in the near future, paying mortgage points is probably bad news.
When it comes to loan origination points, paying less is usually better. This is essentially just more commission for the originating bank or mortgage lender, so be sure to discuss fees with your agent. But often a particular loan is more complicated than another, and requires more processing and/or underwriting time. The lender needs to be compensated for their work, but be sure you know how much they’re getting and why.
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