Whether newly at the helm or a veteran entrepreneur, business owners hoping to buy a new home this year could find rough waters ahead. Mortgages for individuals self-employed in 2014 are likely to fall under even greater scrutiny than in the past.
Congress passed the Dodd-Frank Act of 2010 to avoid another financial crisis. The measure addressed a number of issues, including the predatory loan practices behind the housing market meltdown.
The new mortgage lending rule, including guidelines to assure a borrower met standards for the necessary Qualified Mortgage (QM), went into effect Jan. 10, 2014, and is designed to keep consumers from being approved for mortgages they cannot repay. The rule raises the bar for consumers to qualify for a mortgage loan, with the requirements even more challenging for the self-employed.
Self-employed borrowers have always faced additional challenges securing home loans due to difficulties verifying their income without the benefit of being able to hand over a couple year’s worth of W2s.
Compounding the situation is a lender’s use of net income rather than gross income in determining income level. That means all those deductions self-employed individuals like to take when tax time rolls around will only harm them in the eyes of a mortgage lender who uses tax returns to verify sufficient income for a loan.
Stipulations found under the new QM rules apply to lenders expecting to sell mortgages on the secondary mortgage market to Fannie Mae or Freddie Mac, which applies to the majority of lenders. Lenders must be able to verify several financial criteria designed to determine if a borrower will be able to repay the loan.
The rules goes so far as to allow consumers to sue lenders who fail to properly verify the prospective borrower’s financial information, so there is great incentive for lenders to adhere to the guidelines. One of the critical steps involved is for the prospective borrower to provide a list of assets, a recent credit report, credit scores and evidence of other debts.
Self-employed borrowers, already heavily scrutinized even prior to 2014, will likely find it more difficult to obtain a mortgage because they must prove their income based on multiple years’ tax returns and profit-and-loss statements, rather than the standard pay stubs and W2s that regular employees have at their disposal.
Ability to Repay
More specifically, the “ability-to-repay” feature of QM rules that came into effect in 2014 require all borrowers to provide proof that they have the cash flow to make payments on their mortgage. Self-employed borrowers often have income that varies month to month, and they rely on cash reserves to pay bills during slow periods.
Borrowers have to prove beyond doubt they have the ability to repay. The rules of the game are already stacked against the self-employed because of their often uncertain income. The “Ability-to-Repay” rule takes that challenge and significantly magnifies it by applying more restrictive criteria to receive a qualified mortgage.
This focus on cash flow brought about by the new QM rules can make it difficult for lenders to approve a loan. This can hold true even when a self-employed person has significant funds in the bank, which can leave some self-employed individuals scratching their heads over a loan turn-down.
Demonstrating Income Growth
Unless the prospective borrower can demonstrate stable or, better yet, increasing income, his or her chances of obtaining a mortgage under the new rules now in effect could be slim. Under the new QM rules, it’s questionable how much leeway lenders might feel they have, or how willing they might be to use it, to make decisions regarding mortgage loans for self-employed individuals.
Unfortunately, the current economic and political environment would suggest lenders are not likely to go too far out of their way to qualify borrowers who have anything but a pristine financial history and easily verifiable income. Most lenders will not be willing to risk running afoul of secondary mortgage market guidelines.