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Work For Yourself, Do You?
Years of plotting an escape. Dreaming about never again taking orders from foolish bosses. Never again having to worry about being reorganized out of a job, having good ideas stolen by regional V.P.s, or being transferred to New Jersey.
The great day comes. Your own firm. You're nervous, but it only takes you a year to double your salaryman income. At last, you can trade up to a better house.
No boss, no hassle, no transfer, and...
No mortgage.
One year of self-employment is usually one year short, even to qualify for most "no income verification" loans.
Why this discrimination against people who work for themselves? The self-employed are survivors: tough, adaptable, creative, hard-working. These entrepreneurs are often better long term credit risks than salaried employees vulnerable to restructuring or takeover.
However, many new entrepreneurs fail in spectacular fashion. Mortgage underwriters have learned the hard way that they can't predict which of the self-employed will thrive, and which will crash.
The underwriting solution is cruel: your qualifying income, against which debt ratios will be applied, is the average of the latest two years of income shown on your tax returns. Even more hurtful, "income" is gross business income minus business expenses. This underwriting theory assumes that the income you reported to the IRS was on the lowest possible edge of reality, and if you have made it for two years on your own, you'll make it for good.
These retrospective averages demolish many a reasonable application and applicant. The first year of self-employment usually has start-up costs and low income, which collapse a two year average: zero net income in the first year and $100,000 in the second is a $50,000 average. Forget the house, welcome to your condo.
Lots of people have a splendid third year underway, and want to use a year-to-date profit and loss statement to elevate the average. P&Ls were so often... ah... magnified in the late 1980's that they can only be used if audited.
Just when you are thinking, "Whew. Sure glad I'm not self-employed," think again. If you are on commission only, or incentive, or have multiple employers, or are merely paid on a 1099 (contract without withholdings), or own a fifth of your employer -- two year average, please.
Other loops and traps include changes in your self-employment envelope. For example: new partners last year? Change sales territory, or sales responsibility? Go from base plus to commission only?
Commission only for ten years at one firm, and only six months in the saddle at a new one? "But I've doubled my income at the new shop, and I'm selling the same junk!" Maybe, but ... just maybe.
There are options for the newly self-employed, the low average self-employed, and the recently re-enveloped.
The mortgage options fall into a much-misunderstood loan underwriting soup of "no income verification," "low document," "no document," and even "non-qualification" (in lender slang, respectively, "no ver," "low doc," "no doc," and "non-qual"). Though all of these programs tend to be lumped together by borrowers and Realtors, each is distinct, and has its own advantages and pitfalls.
Low doc loans involve accepting the borrower's assertion of income, and not asking for any proof, not even tax returns. The most extreme form, the non-qualification deal, does not even require a borrower to claim to have income -- no job necessary at all.
All of these alternate routes require a big down payment, somewhere between 20% and 30%, and rest on lender belief that no one would walk away from such a big down payment, and if someone did, nothing bad could happen to the lender. These loans are available only for the cream of properties and the borrower must have a perfect credit record.
Low doc loans are not as easy as they seem. The terms of these loans, and their availability have a way of changing often, even in mid-application. Low doc loans are risky for lenders, and bad experiences cause them to pull back from the market.
For example, the big down payment theory is being tested in California, where some values have fallen 30%, thereby wiping out paid-in equity. The no verification loans also suffer from periodic outbreaks of fibbing by borrowers and their bankers about unverified incomes.
Nearly all lenders have access to some form of limited document loan. However, reliability of outcome is poor compared to the normal, full doc, two year average, self-employment strip search loans. "Reliability of outcome" means, at the moment of application, the degree to which banker, borrower, brokers, and seller are sure there will be a loan approval.
Too often, and inevitably, the low document approval process is like cruising an empty, easy Santa Monica freeway at four o'clock one morning only to have an overpass lurch out from under you. Says the underwriter, three days before closing, "Nice file, but I've got to have those tax returns after all."
If you are contemplating self-employment, or even a mere re-enveloping of your business, get your house buying done first. Or maybe wait a couple of years.
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