Hopes that Americans could finally get more affordable mortgages due to falling interest rates have been dashed in recent weeks as geopolitical tensions are pushing rates up once again.
The average 30-year fixed rate fell below 6 percent in February, the first such dip in three years, but it's now back above that benchmark, at 6.30 percent, while a 15-year fixed-rate mortgage is at 5.65 percent, according to mortgage giant Freddie Mac.
The US-Israel war on Iran has resulted in higher inflation and an energy crisis against wider economic fears in the US and around the world, economists say, helping drive interest rates back up.
For self-employed Americans seeking favorable mortgages, there are additional obstacles. Not only are lenders more reluctant to approve new mortgages in turbulent economic times but they typically hit entrepreneurs with higher borrowing costs and more prohibitive qualifying standards.
And with millions of Americans working for themselves and therefore not part of traditional payroll structures, experts say the mortgage system has become outdated and not fully adapted to this vital part of the economy.
The Heart of the Mortgage Problem
Mortgages are built around the traditional worker, someone hired by a company, on a contract and with a stable income. Otherwise known as W-2 employees, they have the predictable monthly income that lenders want to see, so they know payments will be made and on time. That's proven at the time of application by W-2 tax forms or pay stubs as well as at least two years of tax returns.
For these workers, it's not so much about what they earn but that they are getting a specific sum each month for as long as they're employed. It's financial reliability that can be projected for the duration of a mortgage and backed up by documentation that's standard and easy to verify.
And so, experts say, the mortgage system in the United States is designed to reward this kind of consistency in earnings and struggles when elements of complexity are introduced, such as in the case of those who are self-employed.
The problem becomes apparent when mortgage applications are made by people who are not salaried employers with a steady income of a mostly fixed amount. It includes business owners; contractors and freelancers, considered "1099 earners" by the IRS, because payments are reported on its Form 1099-NEC; consultants with many clients; and also those who work in the casual gig economy.
These people may have strong earnings, as well as substantial assets, but because their income looks less predictable on paper, lenders can often hesitate when approving applications for a mortgage. It comes down to how they assess risk, and in these cases, earnings don't always align with their requirements.
This difference between real and taxable income is what leads to many rejected applications, says Eric Bernstein, president and co-founder of LendFriend Mortgage, a broker with offices in Austin, Texas, and Chicago, Illinois.
“Self-employed borrowers often look weaker on paper because traditional underwriting only takes into account the taxable income shown on the self-employed borrower’s tax returns, where write-offs reduce taxable income even if actual cash flow is strong,” he says,
“Many entrepreneurs take advantage of aggressive tax planning to write off the majority of their income, which impairs their ability to qualify for a traditional mortgage. As a result, the more efficiently a business is run from a tax standpoint, the less income it may show for mortgage qualification.”
Mortgages for Entrepreneurs in Changing Market Conditions
One solution for entrepreneurs and others who don't work directly for a company, says Bernstein, is a bank statement loan. They simply allow applications to verify their earnings based on their bank statements.
“Bank statement loans evaluate income based on actual cash flow rather than tax returns, actual deposits less an expense ratio as determined by the lender or the borrower’s Certified Public Accountant (CPA),” he says.
“Borrowers need to understand that as long as they have at least 12 months of consistent deposits and a letter from their CPA attesting to their expense ratio -- whether that’s 15% or 50% -- they can qualify for a bank statement loan.”
But as more Americans than ever shun traditional jobs and set up their own businesses, things are set to change, with lenders tweaking their requirements to match their income setups and take on new clients, Bernstein predicts.
The Rise of Non-QM Lending
At a time when rising numbers of borrowers are not catered for by traditional underwriting models, a section of the market has grown to meet the demand, with non-qualified mortgages, or non-QM loans.
This type of lending is suitable for people whose finances don't match lenders' standard criteria for mortgage applications, by using alternative methods of assessing ability to repay. This has made them an increasingly popular option for people who are not directly employed.
Such folk often have strong cash flow and valuable assets but are unable to get mortgages the traditional route because they don't fit the rigid application criteria. Typical clients are businesspeople, high-net-worth individuals, real estate investors and also freelancers.
Non-QM loans are not, however, risky subprime loans that triggered the 2007 financial crisis, and while they're outside the rules of government-backed providers like Fannie Mae and Freddie Mac, borrowers are properly assessed for risk and must prove their ability to repay. The difference is in how the risk and eligibility is assessed.
“As the market of self-employed borrowers grows,” says Bernstein, “more lenders will enter the space, pushing service levels higher and rates lower to win more business.”
Reality Check: Trade-Offs and Risks
Non-qualified mortgages are often the best solution to non-traditional borrowers' needs, giving them far greater flexibility than the boxed-in structure of usual loans, but there are downsides that applicants need to consider, experts advise.
The most pressing of these is the cost of non-QM loans. Those seeking this form of financing should expect higher interest rates compared to conventional mortgages, which is due to their increased complexity and risk from institutions' perspective. And as interest rates are currently rising, given geopolitical tensions and other factors, observers say the additional costs can be significant.
Although employment contracts, pay stubs and tax receipts are not required for non-QM loans, applications still need to provide concrete documentation that backs up their financial status and income streams. This can amount to many years of bank statements showing consistent deposits and solid projections of cash flow. Those who don't have regular income and instead have significant gaps in their earnings may not meet the criteria, and so approvals are not guaranteed.
Market sensitivity can also affect investor appetite for this type of lending, and when it enters periods of volatility, they may apply stricter eligibility terms that further reduce access for the self-employed, experts warn.
Where Is the Market Heading?
Partly brought on by the pandemic, as people sought a greater work-life balance, the US workforce has been moving from the traditional salaried employee to more flexible working. It includes freelance and contract work as well as people setting up their own business. Economists say the trend has continued since the pandemic and has created a bigger market of borrowers whose earnings don't match traditional lending models.
As a result, lenders are becoming more responsive to emerging market trends, using different ways to assess earnings and risks, whether it's from bank statements or appraising assets. This kind of flexible underwriting is expected to continue, say financial observers, as the non-traditional mortgage market grows.
And with artificial intelligence and tracking tools increasingly being adopted by banks and other lenders to verify incomes, some see alternative lending solutions exploding even further, offering more attractive methods for self-employed people to get mortgages.
“While borrowers are already well served by existing solutions like bank statement loans, there’s of course room for improvement," Bernstein says. "These borrowers currently face limited lender options, with just a handful of lenders being able to properly service self-employed borrowers.”
A Mortgage System in Catch-Up Mode
The ongoing frustration for self-employed Americans is not a lack of income, experts say, but a mortgage system that is primarily geared toward a different segment of the market, the salaried employee who is viewed as the prize. But the modern workforce has evolved beyond that and lenders are not keeping up.
This has led to the development of alternative lending solutions, like bank statement and non-QM loans, but entrepreneurs often remain at a disadvantage because they generally have to pay more in interest and are more exposed to market volatility. Conflicts that may erupt around the world at any time can swiftly push up borrowing costs, making mortgages less affordable and complicating both applications and long-term financial planning.
For now, observers say, the US mortgage market still favors the employee but has become more flexible while at the same time resisting change. The key is translating self-employed earnings into a format that lenders are willing to accept. And until such time that underwriting evolves further, they say, entrepreneurs and others will be stuck with navigating a generally rigid mortgage system that doesn't always equate financial strength with success.
