As female business owners and entrepreneurs know, running your own business through which business expenses and income flows creates a challenge when it comes to securing credit. Whether it is a business loan for growing your company, or securing a mortgage for your own personal residence, strategy on how you show your income and expenses is critical to getting the loan you want.
Below is a post written for us by one of our trusted resources, Sarah Lindsey, Mortgage Advisor for Craft Home Loans, on how to qualify for a mortgage if you are a business owner or consultant.
I have a client who stumbled across her dream home for sale. She wasn’t looking for a new home, but her dream was available and she wanted to purchase it. I’ve been helping this client and her family for years with mortgage financing and she called me out of the blue explaining her story and the need for a mortgage pre-approval letter to secure financing to buy the home. This client has been in the fitness industry for as long as I’ve known her. Only one year earlier she opened her own fitness studio, and her business was off to an incredibly successful start. She and her husband were making enough money to live in a very desirable area, raise their two children and be financially responsible. She figured she could just contact me for a pre-approval letter and purchase her family’s dream.
Unfortunately, mortgage financing for business owners is not so simple.
I’ve been through this same scenario hundreds of times with clients. Although her business was off to an amazing and profitable start, her ability to write off the startup costs and other business expenses allowed her to reduce her company’s net income on her tax return to almost zero. This is great for tax purposes, but a mortgage bank also sees her business as making “almost zero.” As a result, they can’t qualify for financing.
My client explained to me that her income is a major factor her family can afford to live where they do, and she pays herself a regular wage. Her explanations make sense, but logic and mortgage financing don’t mix. Banks have formulas for calculating business income and that formula creates the useable income for your loan application. This is where the frustration starts for so many business owners I speak with.
If you receive a stable and regular salary from an employer, have some savings and a good credit score, you can go almost anywhere and get a mortgage with relative ease. If you own a business or have any untraditional form of income, unfortunately, it’s a different story.
Stemming from the financial crisis of 2008, the mortgage industry has undergone a complete overhaul and is now federally regulated. The new regulations make the mortgage banks responsible for proving the applicant has the “ability to repay” their mortgage financing. Go figure! If the bank does not prove your eligibility, they are responsible for the loan. What does this mean? If the banks don’t prove, without a doubt, that you can repay your new mortgage, they will be left with the mortgage on their books and if you default on your loan, the bank is responsible for the loss. In most cases, the bank does not want your mortgage on their books and wants to sell it off to other entities for profit. Therefore, mortgage financing requires a tremendous amount of paperwork to prove your financial eligibility.
Paperwork proof for business income comes from tax returns. If you own a business you know you make more money then what your tax return shows. So, what are business owners to do if they want to finance a home? There are a few simple things to remember for mortgage financing success. Plan early with a mortgage advisor, think averaged net, and business sustainability. Just like my opening story, odds are very unlikely for a business owner that you can buy a house on a whim and immediately qualify for financing. I would never suggest buying on a whim in any situation because of the huge tax and financial planning consequences buying a home has and there should always be a plan in place first when purchasing your biggest investment, but that is a topic for another blog. Like everything else involved with being a business owner, mortgage financing will take a bit more planning.
First, and the most important, plan early.
If you have any thoughts of needing mortgage financing within the next one to three years, you need to start planning now with your finance professionals including a Mortgage Advisor on what those needs are. A Mortgage Advisor, like myself, can review your past tax returns to create a baseline of income and work with you, your tax advisor and financial planner to create a plan. Your future income needs will be based on your goals and where a mortgage bank will look for that income for qualifying. Yes, a Mortgage Advisor needs to give advice in your planning stages before you actually need a loan. If they don’t do this, you need a new Mortgage Advisor.
Secondly, think averaged net.
Depending on what type of business you own (Sole Proprietorship, Corporation, Partnership) your income on those tax returns will be looked at in different ways. A general rule of thumb is to remember your qualifying income is based on your net profit/loss and is averaged over two years. If you had a profitable year or took a loss, the bank will take those totals and average over two tax years. Items like depreciation and depletion can be added to your net income totals, but meals and entertainment expenses will be subtracted.
Corporations and Partnerships will have salary, K1’s and the business returns to take into consideration for income. These business gains/losses will be applied to your qualifying income based on your percentage of ownership of the company. For example, if you own 50% of a company that had $100,000 in profits, that will only equal $50,000 in qualifying income for you in that year. If the company has the exact same profits two years in a row that will give you $50,000 in eligible income ($50,00 + $50,000 = $100,000 / 2 = $50,000).
Thirdly, think sustainability.
Mortgage bank underwriters most always determine solvency and sustainability of your business. Along with your two-year tax income averages, they will also look at your year-to-date (YTD) profit and loss (PNL) statements. If your YTD PNL statements show less income then the two-year tax averages we just discussed, they will go off the lower income figures of your current PNL. It’s very important that your YTD PNLs match or show more income then your two-year tax averages. This show your business has sustainability.
The mortgage industry has changed and due to new mortgage regulations, it’s hard for a business owner to prove their income. What’s good for your tax liability is not always good for qualifying for a home loan. By having a basic understanding of the banks requirements and how they look at your income you are already ahead of the game.
Remember to plan early, think averaged net, and sustainability. If you do this, you will experience less surprises and headaches and achieve your end goals faster, in what most business owners consider a difficult financing process.
And in case you were curious, I was able to get my client (from the beginning of this blog) into her dream home. It wasn’t easy and my client experienced extra stress, but we had some creative options with the structuring of her application to make it work.
At WealthChoice we believe every client should have a team of trusted advisors who work together to help you live the life you want. Please contact us if you’d like the names of the advisors we work with.
