The challenges in underwriting for today’s self-employed borrowers

As lenders seek new clients, many are now looking for opportunities among self-employed and small-business owners. But the bar for self-employed borrowers to qualify for a mortgage comes in a bit higher — and so do the challenges for lenders when determining risk factors.

Consumers don’t always realize when taking out a mortgage that the only rule applied to self-employed borrowers is two years of tax returns and a year-to-date profit-and-loss statement, according to Tom Hutchens, executive vice president of production for Angel Oak Mortgage Solutions. The criteria frequently fail to fully capture repayment ability and income of the self-employed, especially when accounting for the tax deductions they take. Relying on taxable-income numbers ends up disqualifying many, making non-QM products necessary. 

“What we believe is that the tax code and the law tax laws, rules and requirements does not necessarily reflect someone’s ability to repay a mortgage,” Hutchens said. His company has offered a product for small-business owners with at least a 25% ownership stake since 2014.

“The tax code is written on behalf of the government to collect taxes. Well, our job is to give loans to people that have the ability to repay us back, and there’s the disconnect.” 

With the mortgage market slowing and not expected to return to the heights of the last two years soon, non-QM lending has moved into the spotlight, particularly bank-statement loan products for self-employed clients, where decisions are made based primarily on analysis of up to 24 months of a borrower’s bank statements. But while potentially lucrative, the quirks of lending to the self-employed require a little more hands-on attention to stave off any risk involved.  

Long-established non-QM businesses, like Angel Oak, might view the current market environment as a prime period to capitalize on their strengths, while the temptation of higher margins of non-QM offerings along with diminished expectations for conforming loans are leading some lenders into the non-QM space for the first time this year. 

InstaMortgage and American Financial Resources have both introduced bank-statement mortgages in 2022. Another, First Home Mortgage, which has long served the small-business community, established an entirely new division called LoanBud in April to specifically offer residential mortgages to not only business owners, but also other types of self-employed borrowers not fitting the mold of a salaried employee, such as freelancers, entrepreneurs and 1099 contract workers.

The effects of the coronavirus pandemic, when many businesses were forced to shut down for months, brought home the need for a bank statement loan program, said Christopher Guerin, American Financial’s executive vice president of origination and business development. While interest rates were low and housing demand was high, he saw “a disproportionate amount of self-employed consumers not able to access any financing.”

“We feel this program, especially with the way that tax laws are written now, really gives an opportunity for small business owners who just went through a pretty tough time to access money and capital,” he said of his company’s product. Like Angel Oak’s offering, American Financial’s bank-statement loan is primarily, but not exclusively, aimed toward small-business owners with a 25% stake. 

But the process behind originating these kinds of loans is more time-consuming, requiring thorough analysis and greater attention to detail. Automation, key to driving efficiency among lenders in recent years, is no friend to the self-employed. According to a study conducted by LoanBud, 50% of self-employed borrowers who received pre-approval for a mortgage, said they were later denied after further review. Approximately 53% of respondents in the study said they had encountered difficulty obtaining a mortgage by using their tax returns. 

“More and more lenders moved to the online, instant quick, pre-approval letter right on your app, and you can write an offer on a home,” said Burke Purcell, director of LoanBud.

But borrowers with more complex income structures, requiring examination of tax returns, bank deposits and profits and losses, learned different rules applied to them.  “Oftentimes, people can put in what they think that they make into that application, but that might not align with what the underwriter comes up with,” Purcell said.

The human touch plays a heightened role in lending to self-employed borrowers, from pre-application to closing, regardless of the exact origination and underwriting processes different lenders take. 

Even if a proprietary automated underwriting system is involved as it is at LoanBud, a set of human eyes complements the process for income verification and statement review. “Typically, we’ll use anywhere from 50% to 85% of the bank deposits as qualifying income,” Purcell said. For 1099 workers, LoanBud might use anywhere from 80% to 100%. 

Purcell also said lenders often require a higher down payment starting at 10%, which serves as a natural buffer against risk.

After an application is submitted to InstaMortgage, the lender has two different underwriters look at applications to determine the quality of applicants, said Shashank Shekhar, the company’s president and CEO. InstaMortgage offers loans based on either six or 12 months of bank statements. 

He also added that extra diligence can begin with the applicants themselves when they and their accountants determine net income and tax deductions. While the accountant’s expertise can be invaluable in reducing a tax bill for the self-employed, it might not be as helpful when applying for a mortgage.

“The only thing you’re really changing is the income requirement, and with income requirements, what you’re looking at is the different ways of verifying income. You don’t want to take on too much risk by being extremely creative,” he said. 

“Our processes are maybe just a little bit more upfront gathering documentation such as bank statements and things of that nature,” Hutchens said of Angel Oak’s procedures, but added that despite the extra labor needed, little additional time was required in loan closing compared to an agency transaction once all documentation was received. Asset and collateral review were no different, Hutchens said.

“We’re able to see the whole picture through manual underwriting and analysis,” Hutchens said. In addition to having account executives work with originators on pre-approval, Angel Oak also places heavy emphasis on a client’s FICO score and factors such as payment shock, or how much more the borrower will need to remit, when determine a client’s potential to repay. The company also owns the servicing of the loans, giving it additional incentive to undergo sound risk assessments.

“We don’t look at everything just in it exclusively, but you start to kind of draw a picture of it,” Hutchens said. ”That’s the beauty of non-QM. We’re able to kind of evaluate that risk individually.”

To protect itself further from borrower risk, American Financial Resources requests additional documentation, Guerin said. 

“We do ask for a letter from a CPA or licensed tax preparer, prior to closing if the borrower is still self-employed,” he said. “We do check the bank statements to make sure they’re in 120 days and also show a stable and increasing trend in terms of new deposits.”

The emerging need to be able to understand the quirks of lending to the self-employed has grown large enough that Amy Slotnick requires outside self-employed-borrower trainings for new loan officers and loan officer assistants in Fairway Independent Mortgage’s internal coaching program, Ignite. Slotnick serves as senior vice president and regional manager for Fairway in Newton, Massachusetts, and an instructor with Ignite.  

She also says that self-employed borrowers and business owners are not limited to non-QM products. Those meeting criteria can apply for conventional and jumbo loans as well as Fannie Mae and Freddie Mac-backed loans. Shekhar also advised that self-employed borrowers with enough documented income to qualify might be better off applying for a government-sponsored-enterprise loan.

But the same amount of detail and knowledge is required when dealing with any self-employed borrower application, just as would be needed with non-QM mortgages.    

“A loan officer who is not familiar with self-employed borrowers may not properly calculate or correctly calculate the income that can be used in qualifying that borrower,” Slotnick said. 

Even with greater adoption of automated tools, they can’t be relied upon when determining borrower eligibility. “The technology doesn’t know the guidelines,” she said. “So it will calculate the income, but then the underwriter has to say, Can that income be used?”

The nature of lending to self-employed borrowers, and non-QM loans in general, naturally demands elevated caution and careful, smart, decision-making from mortgage companies, according to Hutchens.

“We work really hard to mitigate our risk, but we’re also in the risk-taking business,” he said.

“You’re giving someone else lots of money and just counting on them paying you back.” 

The greater danger of making loans for businesses like Angel Oak  might come on a macro level, Hutchens added. “One of the things we often heard was, ‘Well, yes, they perform well, but they’ve never been stressed,’ ” he said. 

“Well, I would certainly now say COVID was a stress on the self-employed marketplace, and our loans performed very well during and after COVID.”