If you’ve bought a house in the past, you are probably familiar with the underwriting process involved when obtaining a mortgage. You might even have nightmares about the reams of paperwork you had to provide to your mortgage lender to get approved.
Being approved for a mortgage is not an easy process. For business owners it’s even more complex. Typically mortgage lenders provide pre-approvals based on some combination of your W-2 income history, pay stubs, or an offer letter from an employer. Unfortunately for business owners, these sources may not show consistent income a lender could use in a standard approval.
So what do you do? Recently I had Maggie Hopkins, a local Sacramento mortgage lender, on the podcast. Since she shared so much valuable information on the episode (and because I love re-purposing content), I thought I’d summarize the important points on the blog this week. If you own a business, here’s what you need to know about obtaining a mortgage.
The Typical Mortgage Underwriting Process
Like any bank, mortgage lenders want some assurances that they’re going to get their money back, plus interest, before giving any to you. So, when you walk into your mortgage lender and ask for financing, they’re going to ask for your tax returns, pay stubs, credit reports, and any other documents that might be relevant.
If you’re an employee collecting a w-2 salary, lenders may be willing to assume that income will continue indefinitely. They’ll also take your other debt into consideration, and use some type of debt to income ratio to determine how much they’re comfortable doling out.
If you don’t have a w-2 salary that doesn’t mean you can’t get a mortgage. But it does likely mean that you can’t get a conventional mortgage, that meets the down payment and income requirements established by Fannie Mae and Freddie Mac.
It also means lenders will look at your other sources of income. And for self-employment income, lenders historically use the average of your last two years. Doing so helps them confirm that your business profits are not a short term “flash in the pan” that might disappear next month.
This can be less than convenient, since net profit is usually the only metric that matters. Any type of fluctuation in bottom line profits in the last two years could impact your pre-approval amount or your eligibility entirely. Funding a big expansion or other expenses that might crimp profits over a short period of time tend to work against you. So do gray area personal expenses you might be running through your business: home office deductions, cell phone bills, etc. Anything that depresses your income, while ordinarily “good” for tax reasons, may mean you’re not able to obtain as much financing as you’d like.
Other Mortgage Options for Business Owners
So what are your options if the last two years haven’t been stellar? An obvious answer would be to wait it out. Take a two year period where you cut expenses as much as possible in order to prove adequate self employment earnings. Or simply grow revenues. (Although I should add, from a business management standpoint, growing revenues is not always the answer, and can lead to more pain than gain).
Another option is to pursue what’s called a “bank statement loan”. Whereas banks have been exceptionally rigid with their underwriting policies and standards since the mortgage crisis in 2009 (for good reason), they are starting to loosen more recently. Some lenders are beginning offer mortgages based on the deposits to your business bank account – not your tax returns or pay stubs.
As Maggie shared with me, these are typically 5, 7, and 10 year adjustable rate mortgages (ARMs). Which isn’t quite as appealing as a borrower in this low interest rate environment as a longer term fixed rate mortgage would be. Nonetheless, it can be very helpful. And you can always refinance later if your business income becomes more consistent over the few years after obtaining one.
Conventional mortgages require 20% down payments. Coming in with less than amount isn’t a deal breaker, but it means one of two things:
- You need to obtain an FHA loan and private mortgage insurance
- You need another type of unconventional (non-conventional?) loan on less favorable terms
FHA loans can be extremely helpful. You can put down as little as 3% since the FHA is guaranteeing the mortgage. The downside is that you have to pay private mortgage insurance (PMI), which can be anywhere between 0.55% and 2.25% per year. That’s added to the interest you’d pay on the loan anyway.
The alternative is to work outside the bounds of conventional loans. Realistically this means letting your mortgage broker go to work for you. Mortgage brokers can work with any number of different lenders, and should have a good understanding of which banks tend to offer the best terms for your situation. While you don’t necessarily need to pay private mortgage insurance if you have less than 20% down, do expect to pay a higher interest rate. Maggie also shared with me that while it’s possible to obtain a bank statement loan with less than 20% down, you’re probably not going to like the rate & other terms.
What to Make of Points, Rates, Closing Costs, and other Terms
Then there’s the question of points, rates, closing costs, and terms. One of the biggest takeaways I got from Maggie was that mortgages are one big package deal. Lenders try to ascertain your capacity and willingness to pay off the mortgage, and then extend an offer accordingly. Better credit scores mean that you’ll get more favorable terms. Negative marks on your credit history mean you’ll end up paying more.
From there it’s all negotiable. You can squeeze your annual interest rate down by buying points & paying more up front. Which could be a good idea if you’re certain you’ll stay in the house for the entirety of the loan. But that may not be your best option. At the end of the day the rate, closing costs, and term should all be aligned with your objectives for the property. If it’s a flip, pick the loan with the lowest possible down payment and closing costs. If it’s your forever house, scrutinize the rate.
At the end of the day, your mortgage broker’s job is find a lender to offer you a loan on the most favorable terms and the right structure. There are a ton of moving parts in the mortgage world. Just because you don’t have 20% down or two years of schedule C income doesn’t mean you can’t get into a house. Even if you own a business that doesn’t produce consistently high self-employment income.