Residential Mortgage Underwriting

The following is an excerpt from Chapter 2 of Volume II of The Mortgage Professional's Handbook:


Shelley Callaghan - Senior Marketing Program Manager
Vicki Woeckener - Manager, Credit Policy
Deya Araiza - Underwriting Production Manager

You’ve heard the clichés: Follow the money. Cash is king. When it comes to underwriting single-family residential mortgage loans for self-employed borrowers, these should be considered truisms. But to be even more precise, perhaps we should specify that cash flow is king.

Analytical skills and sound judgment are certainly necessary when evaluating self-employed borrowers. Determining whether they can and will repay a loan is difficult because obtaining an estimate of their earnings from tax returns can be confusing.  The challenge is that accountants for self-employed borrowers are experts at reducing tax liabilities by minimizing current net income, while we as mortgage loan underwriters rely on that same net income as a gauge of the borrower’s earnings.

The tax return reveals the borrower’s taxable income. But what you are really looking to ascertain is the borrower’s cash flow, because that is what the borrower will use to pay back the loan.

Risk Factors
The variable nature of self-employed income represents a greater risk than W-2 income because the borrower’s day-to-day living and housing expenses are fixed. Some factors to consider:

  •         Is the business and industry stable, diversified and competitive? In other words, how healthy is this business?
  •         Does the borrower have a good credit history and credit score? A poor personal credit history could indicate a cash flow problem in the business and prevent the business from obtaining additional financing if needed.
  •         What is the marketability of the property? If the business fails and the borrower loses his/her income, the property is the only asset collateralizing the loan.

Typically, the industry considers a borrower self-employed if they have 25% or more ownership interest in a business. Because the income is variable, most investors require a two-year history of self-employment and require two years of signed and dated tax returns to document income that is stable and likely to continue.

Legal Structure of Business
Before you can determine the income documentation you will need, you must first understand the different business structures:

  •        Sole Proprietorship
  •        Partnerships
  •        General Partnership
  •        Limited Liability Company (LLC)
  •        S Corporation
  •        C Corporation

Basic Cash-Flow Analysis Concepts
Why use tax returns? You can get a snapshot of a wage-earners income from a W-2 form, paystub, or Verification of Employment (VOE). But a self-employed borrower is different. There is no “independent third-party” to verify employment and income. The most credible source of documentation is the tax returns that have been submitted to the Internal Revenue Service (IRS). Unfortunately, tax returns are not designed to provide a clear picture of cash flow. But, with an understanding of some basic concepts and careful analysis, from those tax returns you can determine the self-employed borrower’s cash flow and whether he or she has sufficient income to qualify for the loan.

Tax returns are a starting point for analyzing cash flow. Income is increased by the noncash expenses and decreased by any real losses or expenses that were not included in the taxable income. As you can see, before you can dive into analysis, it’s important to know what is considered income, expense, or loss. Once you understand these basic concepts, you will have a good foundation for conducting a meaningful analysis of both personal and business tax returns. There are three key income/expense components that appear throughout the cash flow analysis ─ noncash expenses, recurring versus nonrecurring income or loss, and losses and expenses limited by the IRS.

  •        Noncash Expenses: There are generally three types of noncash expenses: depreciation, depletion,  and amortization. They are deducted from the business’ earnings just like cash expenses such as rent, supplies, and wages. These write-offs are a way for the business to spread out the cost of a long-term asset over its useful life. Because these items do not involve a payment to anyone, they can be added to the borrower’s cash flow.
  •         Recurring Versus Nonrecurring Income or Loss: A recurring income or expense item is one that can be expected to continue over time. Generally, the income should be expected to continue over the next three to five years before it can be considered for cash flow. The more the borrowers have to rely on that income to repay the mortgage, the more important it is for that income to continue long into the future.
  •          Losses and Expenses Limited by the IRS: In certain situations, the IRS has limited the amount of loss or expense that a taxpayer can declare. When this happens, the individual reports a taxable income that is higher than what was actually received. A negative adjustment to income will reflect the lower cash flow.

More on Cash Flow
When analyzing cash flow, generally, two years tax returns are required to document the borrower’s history of receiving the income, and to determine that the income is stable and likely to continue into the foreseeable future (typically for at least three years). However, in some cases, when an automated underwriting system is used, only one year’s tax returns may be required.

Cash flow from the business drives the borrower’s income, which will be used to pay back the loan. The underwriter analyzes the tax returns to determine if the self-employed borrower’s monthly income will be sufficient to make the monthly payments on the loan.  The cash flow needs to be quantified, and a monthly qualifying income figure needs to be calculated. Cash flow for a self-employed borrower is typically determined by two common methods: the Adjusted Gross Income (AGI) method and the Schedule Analysis Method (SAM). The AGI method begins with the borrower’s most recent two years’ gross total income before adjustments and is adjusted to account for regular/recurring income and neutralizing the income that will be evaluated from each schedule. SAM looks at the income/loss for each tax schedule allowing the underwriter to focus only on the schedules that will be used for determining cash flow, ignoring non-self-employed income sources such as W-2 earnings from employment or Social Security. The method you use may depend on investor requirements, company policy or personal preference. Either method should result in the same cash flow for the borrower.

To determine the borrower’s cash flow, you’ll typically start by analyzing two-years of personal tax returns (Form 1040 and applicable schedules) and then two-years of business tax returns. When reviewing the 1040 tax form and accompanying schedules, you’ll focus on the key income/expense components and add all noncash expenses (such as depreciation, depletion and amortization) that impact the borrower’s cash flow.

  •      Schedule C: Profit and Loss From Business: Generally analyze two years of Schedule Cs.
  •      Schedule K-1 (Form 1065): Partner’s Share of Income, Deductions, Credits, Etc.: Determine borrower’s ownership percentage and therefore their share of the income/loss. Income may be used to qualify provided that there are positive sales and earnings trends, adequate liquidity in the partnership, and the borrower can document access to their share of the income.
  •       Schedule K-1 (Form 1120S): Shareholder’s Share of Income, Deductions, Credits, Etc. Same as above except used for an S Corporation.
  •      W-2 Form (Wage and Tax Statements) from Borrower-Owned Corporation: W-2 wages paid to the borrower from their corporation can be added to cash flow, provided you can document that the corporation is viable.

After analyzing the 1040s (personal tax returns), you’ll move on to looking at two years of business returns for Partnerships, S-Corporations and C-Corporations. Whether or not you will be using additional income from a partnership, S Corporation, or a regular corporation to qualify your borrower, you should still conduct an analysis of the business tax returns to ensure a consistent pattern of profitability. Generally, most investors allow the income to be used as long as the analysis shows profitability, the business is viable, has sufficient liquidity,  and the borrower can document his/her ownership.

  •         Form 1065: U.S. Return of Partnership Income, Form 1120S: U.S. Income Tax Return for an S Corporation and Form 1120: U.S. Corporation Income Tax Return:  Remember to add or subtract only the borrower’s share of income or losses. The borrower’s ownership percentage can be found on Schedule K-1 (Form 1065).
  •         Year-to-Date Profit and Loss and Financial Statements:  Depending on the time of year you are analyzing tax returns, it may be helpful to obtain a profit and loss statement and financial statement to provide a current snapshot of a business over a given period of time (it may be a calendar year or a fiscal year). These documents are not generally used for qualifying the borrower but rather to support income history, and the growth and stability of the business. Some investors may allow the income identified on the profit and loss statement to be considered only if the income is in line with the previous year’s earnings. This income may also be considered if it is reported through audited financial statements.

Summary for Self-Employed Borrowers
Your objective in analyzing the tax returns, regardless of the business structure, is to determine that the borrower’s business supports a stable income history and will provided continued cash flow necessary to repay the loan. Remember, when it comes to determining a self-employed borrower’s ability and capacity to repay, cash flow is king.

Read the rest of this chapter in The Mortgage Professional's Handbook!

Deya Araiza, MGIC Underwriting Production Manager, joined MGIC in 1998 and is currently the Underwriting Production Manager for the Seattle office.  She manages a team of underwriters focused on MI only business and is responsible for their overall productivity and work quality.   Her experience extends to Contract Underwriting having managed both Contract and Mortgage Insurance teams during her time with MGIC.

 Shelley Callaghan, MGIC Sr. Marketing Program Manager, joined MGIC in the mid 80s and currently serves as a Senior Marketing Program Manager. She is primarily responsible for MGIC's online and classroom technical training programs. Through the years, she’s worn many different hats, including managing an MGIC Underwriting Service Center and working on MGIC's national Field Operations team. Her technical savvy is built on her extensive, practical experience and drives the value she places on a strong technical foundation.

Vicki Woekener is a Manager for Credit Policy for Mortgage Guaranty Insurance Corporation (MGIC).  In this capacity, Vicki is responsible for policy and program review team with a primary focus on interpreting and operationalizing underwriting and credit policy requirements.  Vicki has held a variety of positions at MGIC since 1997 including Risk Analyst, Loss Mitigation Specialist, and QC Underwriting Analyst. Her career in the mortgage industry spans over 30 years with a variety of responsibilities including new product development, wholesale operations, retail team leader, affordable housing and private banking team coordinator.