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Understanding and Documenting Self-Employed Borrowers
After carefully evaluating a borrower's income and employment history, it is up to you to determine that a borrower demonstrates the financial ability to repay a mortgage. This tutorial provides Freddie Mac's definition of a self-employed borrower and the types of business classifications under IRS guidelines. It will also help you calculate, verify and document self-employment income so that Loan Prospector® can return an accurate assessment.
For more information and required income qualifications and documentation requirements for self-employed borrowers, refer to Freddie Mac's Single-Family Seller/Servicer Guide, Volume 1, Chapter 37, sections 37.13(b) and 37.21 through 37.23.
General Guidelines
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Freddie Mac considers a borrower to be self-employed if they own 25% or more of a business—regardless of how much the business contributes toward their total income.
- A two-year history of self-employment is recommended to ensure that income is stable. Less than two years of self-employment may be acceptable under certain circumstances.
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On a borrower's federal income tax return, the following items may be added back to adjusted gross income for the purpose of determining qualifying income:
- Noncash items such as depreciation, depletion and amortization
- Documented nonrecurring losses, such as casualty losses
- Loss carry-overs from previous tax years
- The documentation required for a self-employed borrower varies based on the documentation level returned on Loan Prospector's Full Feedback Certificate
Types of business owned by the self-employed borrower
Sole Proprietor
General and Limited Partnerships
Corporation
S Corporation
Limited Liability Company
Questions to ask yourself when assessing self-employed borrowers:
- Who does Freddie Mac consider to be a self-employed borrower?
- Are self-employed borrowers assessed differently than employed borrowers?
- If a self-employed borrower recently had a bad year but had other successful years, is qualification ruled out?
- What should you do to ensure both your QC area and Freddie Mac’s QC can easily determine how you calculated the income?
Resources
- Understanding and Documenting the Self-Employed Borrower webcast
- Freddie Mac's Single-Family Seller/Servicer Guide, Volume 1, Chapter 37, sections 37.13(b) and 37.21 through 37.23 (accessed through AllRegs®).
- Documenting Income and Employment, a 90-minute live web conference
- Loan Prospector Documentation Matrix
Take a look at some worksheets available to assist you in calculating self-employment income:
Cash Flow Analysis Worksheet
Business Flow Analysis Worksheet
Schedule Analysis Worksheet
Answers
1. Who does Freddie Mac consider to be a self-employed borrower?
A Borrower who has an ownership interest of 25% or more in a business is considered to be self-employed. The business may be a sole proprietorship, a partnership (general or limited), a corporation or an S corporation.
2. Are self-employed borrowers assessed differently than salaried borrowers?
A self-employed borrower introduces an additional layer of risk to a mortgage request due to the uncertain nature of future income.
Statistical data supports that most new businesses will fail within the first 2 years and delinquencies tend to be 2 to 3 times that of employed borrowers. Some high-risk occupations include:
- Restaurants – lots of competition
- Retail – specialty shops depend on demand. What was "hot" or "trendy" yesterday, may no longer be the "in" thing today
- Landscaping and Construction – seasonal and supply demands
- Tourism – can decline when events occur that cause interest to decline – for example hurricanes have caused hot spots like New Orleans and Gulfport to lose millions in tourism revenue
Loan Prospector will take this additional risk into consideration in the overall risk assessment. You must indicate to Loan Prospector that a borrower is self-employed in all cases whether or not the self-employment income is used to qualify the borrower.
3. If a self-employed borrower recently had a bad year but had other successful years, is qualification ruled out?
A bad year could be due to medical illness, divorce, death, or other uncontrollable situations. If the business has an overall successful track record, qualification is still possible as long as documented stable monthly income can reasonably be expected to continue at the same or higher level for the next three years.
4. What should you do to ensure both your QC area and Freddie Mac’s QC can easily determine how you calculated the income?
Provide a worksheet, notate the transmittal summary or add a memo to the file showing your calculations.
Exceptions to the Two-Year Employment History Requirement
Unlike employed income, we do recommend your self-employed borrower exhibit at least a two-year history to ensure stability. There are two exceptions to this recommendation:
- If you submit the transaction to Loan Prospector for assessment and receive results indicating a documentation level of Accept Plus, there is no minimum recommended time the borrower be self-employed because your borrower has demonstrated through their credit history alone both the willingness and the ability to repay their debt.
- If you determine there are other aspects of the loan that offset the risk of self-employment for less than 2 years. Keep in mind it may be difficult to determine the stability of a business which has been in existence for less than 2 years unless the borrower has a previous history of successfully managing a business that can be documented. Some examples of this may include:
- Borrower purchased an existing business. You may need to provide tax returns from the previous owner to demonstrate business earnings
- Borrower’s previous work history was in same line of work and they have now started their own business
- Borrower becomes a partner in a firm they already work for
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