January 4, 1999
"I am self-employed and
want to purchase a house. When I went to a mortgage broker for a loan, he
wouldn't give me the time of day! I can't believe that the system doesn't work
for people like me."
It does work for
people like you, but it is somewhat more complicated and onerous. The broker you
went to is probably busy with refinance business, which is often quick and easy,
and doesn't want to be bothered with deals that take a lot of time. But there
are plenty of others out there that will welcome your business.
Interestingly enough, I have been in at
least 6 less-developed countries where it was impossible (as opposed to
"more complicated and onerous") for a self-employed person to obtain a
mortgage loan from an institutional lender. Their only sources of funding, other
than family members, are money-lenders, who charge extortionate rates and break
their legs if they don't pay.
A major problem with lending to the
self-employed is documenting an applicant's income to the lender's satisfaction.
Applicants with jobs can provide lenders with pay stubs, and lenders can verify
the information by contacting the employer. With self-employed applicants, there
are no third parties to verify such information.
Consequently, lenders fall back on
income tax returns, which they typically require for 2 years. They feel safe in
relying on income tax data because any errors will be in the direction of
understating rather than overstating income. Of course, they don't necessarily
feel safe that the W-2s given them are authentic rather than concocted for the
purpose of defrauding them, so they will require that the applicant authorize
them to obtain copies directly from the IRS.
The support it provides to self-employed
loan applicants is an unappreciated benefit of our income tax system. It may not
be fully appreciated, of course, by applicants who have understated their
income. In countries where virtually no one pays income taxes because cheating
is endemic, tax returns are useless for qualifying borrowers.
The second problem with lending to the
self-employed is determining the stability of reported income. For this purpose,
the lender wants to see an income statement for the period since the last tax
return, and in some cases a current balance sheet for the business.
The two government-sponsored
enterprises, Fannie Mae and Freddie Mac, who purchase enormous numbers of home
loans in the secondary market, have developed detailed guidelines for qualifying
self-employed borrowers. Lenders looking to sell such loans to the agencies must
follow the guidelines. The problem is that implementation can be complicated and
time-consuming, especially when the declared income comes from a corporation or
a partnership. (If you own 25% or more, you are considered as
"self-employed"). The mortgage broker who brushed you off didn't want
to take the time, or may not have had anyone available with the skills needed to
do it.
Most lenders offer "limited
documentation" or "reduced documentation" loans to self-employed
applicants who cannot demonstrate two years of sufficient income from their tax
returns. These programs vary from lender to lender, but they all provide less
favorable pricing and/or tougher underwriting requirements of other types.
Lenders invariably require larger down-payments, and may also require a better
credit score or higher cash reserves. In addition, they may limit the types of
properties or types of loans that are eligible.
The bottom line is that the system does
service self-employed borrowers. While the hurdles are somewhat higher than they
are for borrowers who work for third parties, the self-employed are also a
highly resourceful group. If they can't get satisfaction from one mortgage
broker or lender, they'll keep shopping until they find one who can meet their
needs.
Copyright Jack Guttentag
2002
