In
response to abusive lending practices that helped contribute to the
housing meltdown of the past five years, the federal Consumer Financial
Protection Bureau was charged with devising the new mortgage rules. The
goals of these new rules are simple: to help ensure that lenders make
loans only to people who actually are able to afford their payments.
These new rules place emphasize a person’s ability to repay. In
particular, the federal agency wants lenders to look at borrower’s
debt-to-income ratio, how much money a person makes each year or month
vs. total debt and monthly payments. In almost all cases, the amount of
debt must stay below 43 percent of a borrower’s income. The intent is reasonable, the rules sensible. But like many things, these changes have unintended consequences.
And
I’m betting it’s going to be a heck of a lot harder for people who are
self-employed or own a small business to qualify -- assuming the
business is run as a sole proprietorship, limited liability company or S
corporation and income passes through to a personal tax return.
Why?
The very sensible provisions were designed for people who receive
paychecks rather than run businesses. Small-business owners and the
self-employed are likely to have greater challenges with some of the
provisions:
Verified income. For a small-business owner, verifying income depends on tax returns.
During
the mortgage crisis, the notorious no-doc — no documentation — loan
became widely misused. But it meant a lender could look at factors such
as total net worth when evaluating credit worthiness. That made it
easier for entrepreneurs to qualify.
Income. If you get a paycheck, your income is fairly clear.
But
small-business owners and the self-employed often show lower total
income on tax returns than their actual capacity to pay. Sure, some of
this is because they are pushing the limits on what’s legally
deductible, perhaps the kids’ school needs deducted as office supplies.
And a small percentage of business owners cheat. I’m not asking for sympathy for that.
But
the major reason small-business owners show lower income is because of
good tax planning and reinvestment in the growth of their businesses.
Debt-to-income ratio.
Lenders naturally want to see that a potential borrower is not in over
his head in debt — credit cards, car loans, consumer borrowing.
But a business owner is very likely to have debt used to run a company that shows up as personal debt. You
may have a line of credit to purchase goods or raw materials for orders
already received. You may have debt on vehicles used for deliveries.
A line of credit may show up on your personal credit report as debt even if you’re not drawing from it.
Sufficient assets. A borrower has to have enough assets to pay back the loan.
But an entrepreneur’s greatest assets likely won’t count.
I have a great relationship
with my bank, but the bankers consider my most valuable asset, my
company, to be worth absolutely nothing when considering my net worth.
My company’s debts count against me but not its worth. Also
keep in mind that for most self-employed individuals and many
small-business owners, their home is also their office. This means they
could need an extra bedroom and storage space, driving up the cost of
housing. And a high
percentage of people who are self-employed live in urban areas because
of greater business opportunities. All that means higher prices and
bigger mortgages. So what can you do if you are considering refinancing or buying a home? Take action this year before the new rules go into effect. Mortgage rates are low now, too. If you’re buying a home, increase your down payment so your total mortgage and payments are lower. And
if you know you are planning on buying a home, make certain your tax
planning doesn’t lower your taxable income unnecessarily.
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