Lenders have been rolling out a wide variety of alternative documentation loan options over the past couple of years. Borrowers who have had challenges providing traditional loan documentation now have an increasingly diverse array of creative loan options to consider. These loan programs are opening doors that would otherwise be closed for qualified buyers to realize their dreams of homeownership and grow their wealth through real estate investments.
These new programs are of a different sort that were part of the mortgage crisis. In 2010, Congress passed Dodd Frank. Dodd Frank created an “ability-to-repay” (ATR) rule that is applicable to all residential loans. At one point, it was and commonplace for a lenders to base a loan exclusively on a borrower’s credit score and down payment, with no requirement to consider capacity to pay. The ATR rule (which went into effect in January 2014) now requires that lenders make a “reasonable and good faith determination” that a borrow has the means to repay a loan before extending credit.
Although this rule mandates that lenders verify borrowers have the ability to repay, it does not specify how they do it. This flexibility with regard to the “how” end of things has lead to an expanding realm of creative loan options.
Qualified Mortgages (QM) and ‘Appendix Q’
Although Dodd Frank does not specify how lenders test for the ability to repay, it does contain a reward for lenders who to stick to the old school, tried-and-true ways. Loans documented according to traditional methods (with pay stubs, W-2s, tax returns) that also check a few other boxes (limiting risky loan features, fees and debt-to-income ratios) are considered “Qualified Mortgages” (QM). Lenders are exempt from certain legal risks on QM loans.
The required documentation and methodology to meet QM rules is outlined by the CFPB in Appendix Q (scintillating reading for your next sleepless night). Anything that doesn’t meet these rules is considered a “non-QM” loan. (As an industry, we are not very creative when it comes to naming things, are we?)
Coloring outside the lines
A few years ago, there were very few non-QM loan programs available. Recently, however, non-QM lending options have exploded. More and more lenders are willing to color outside of the QM lines and get creative about how we document a borrower’s ability-to-repay.
Four flavors of Alt Doc
So what are these newfangled loan options anyway? The alternatives to QM income documentation fall into four general categories:
• Limited documentation loans
• Asset-based loans
• Bank statement loans
• Debt Service Coverage loans
Each program has its own target audience and answers challenges and opens the door to financing a different group of otherwise difficult-to-finance borrowers. Let’s break each down…
The simplest form of alt doc programs are ones that use traditional documentation, just not as much of it as would usually be required. Traditional loan guidelines call for a self-employed borrower to be in business for at least 2 years and to provide the most recent 2 years of filed federal income tax returns. An underwriter will then average 2 years of net earnings to determine qualifying income.
Our limited documentation loan options require that the borrower provide only 1 year of filed tax returns.This deviation from the norm can make all the difference when a borrower’s business is fairly new and had one-time start-up costs on the first year tax filing and/or is growing rapidly. By looking at just one year of tax return, we get a more realistic picture of the ongoing income the business will generate. This can also be useful for self-employed borrowers with highly variable income from year-to-year.
We even have a few loan programs open to extending loans to self-employed borrowers who’ve been in business for more than 1 but less than 2 years. These loan options are case-by-case and require the borrower document experience in their field, prior to becoming self-employed.
Asset-based loans come in a few varieties. They are designed as a loan option for borrowers with substantial assets, but little income (or even no income). They are a common sense solution to a real problem…
It’s 2009 and you want to buy a new home. You have your eye on a $400,000 house and want to put 50% down. You have no debt, great credit and a $5 million investment portfolio. You don’t work. Your investments have lost a little money in recent years (2008 and 2009 were rough years for the market, after all), so your tax returns show zero income. Your loan application is declined due to insufficient income.
Today, thankfully, we have asset-based loans to offer clients such as this who are credit-worthy from a common-sense standpoint. These programs fall into two categories: “employment-related assets” and “asset-depletion”.
Employment-related asset programs are designed for borrowers of retirement age (typically 59.5 years old) who have have accumulated a sizeable amount of retirement assets, but are not yet drawing on them (or are not drawing all that much).
Eligible employment-related assets are those that are in a retirement account (IRA, 401k, SEP, etc), those we can show were recently disbursed from a retirement account or pension plan or funds derived from the sale of a business. Generally the assets must be available to the borrower without any penalties for early withdrawal.
To calculate qualifying income, the eligible assets are added up and run through a formula — for example, 70% of assets divided by 360. Fannie Mae, Freddie Mac and a good number of our jumbo investors give the option of asset-based income calculation methods built into (for lack of a better term) their “normal” loan guidelines.
Rates and closing costs are no different for loans using traditional income calculation methods, but loan parameters may be limited. A larger down payment, higher credit score or borrower occupancy as a primary or secondary residence is generally required to qualify.
Asset-depletion loans are for borrowers who may or may not be of retirement age. Similar to the employment-related asset programs, assets are tallied up and run them through a formula to derive qualifying income.
These programs vary a good bit from one to another. Most allow us to include both retirement and non-retirement assets in our figuring, although retirement assets-for borrowers not yet of retirement age may be adjusted downward to accommodate the penalty if funds were actually withdrawn. Some require evidence that the assets used to figure income have belonged to the borrower for at least a year.
The formulas used to derive qualifying income from assets range from dead simple (qualified assets divided by 84) to really complex (calculations involving assumptions about market-based rates of return over various timeframes). But you can think of all of these programs as, in essence, “annuitizing” the borrower’s assets for loan qualifying purposes.
Bank statement loans
My parents ran a small businesses while I was growing up, so I know, firsthand, how different the day-to-day budget of a self-employed family can feel relative to taxable income the IRS sees. CPAs work hard for their self-employed clients, maximizing deductions and minimizing their tax liability. Which is all well and good… until it comes time to apply for a mortgage.
Bank statement loans offer self-employed borrowers to keep their tax returns to themselves and to document their income using cash flow. Borrowers provide the most recent 12 or 24 months of bank statements. The lender analyzes cash flow to determine qualifying income for the loan.
Most bank statement programs offer the option to provide either personal or business bank statements. When using personal bank statements the qualifying income is the monthly average of 100% of the transfers from the borrower’s business account to their personal account.
When using business bank statements, gross income is simply the total of all regular deposits to the business account. From that total a deduction of some sort is made to account for operating expenses. The borrower’s qualifying income for the loan is the net the gross deposits less expenses, adjusted to reflect the borrower’s percentage of ownership in the business.
The figure used for expenses used varies by program. Some keep it simple and a set percent (for example, 50% of deposits = income). Other programs use an expense ratio provided by the borrower’s CPA or calculated from a profit and loss statement. And a few programs use the transaction activity on the bank statements themselves, calculating business expenses by adding up all debits on the bank statements.
As recently as a few months ago, I would have told you these programs carry far less favorable terms and were only available with adjustable interest rates. But that has changed. We can now offer fixed rate options and terms much closer to traditionally documented loans.
Debt Service Coverage
Debt service coverage (DSC) loans are for real estate investors. They take an approach typically used for financing commercial real estate and apply it to residential property.
When financing residential real estate (houses, condos, townhomes, duplexes, triplexes and four-plexes), lenders focus on the borrower’s debt-to-income ratio.This is true even when financing a rental property. If a borrower has enough other income residential loan programs permit financing a cash flow negative rental.
When financing commercial property (office buildings, warehouses, apartment buildings with 5 units or more), negative cash flow is not allowed. In fact, the amount of financing available for a commercial property is directly related to the income and expenses. Most commercial loans require that the income the property generates must be at least 1.2 to 1.3 times the expected operating expenses. This is called a Debt Service Coverage ratio.
Residential DSC loans are, in essence, a commercial-style loan for a residential property. No income documentation is required from the borrower and no debt-to-income ratio is calculated. The borrower must simply show the source of funds for closing, meet a minimum credit score and a few other basic criteria.
As in commercial financing, loan is based on the cash flow the property generates. The appraiser’s determination of market rent must equal or exceed the total monthly payment by the percent required by the loan. The programs we currently offer require rental income of 100% to 125% of the monthly payment.
DSC programs can be a great option for foreign nationals, with no US residency, looking to buy real estate in the US.
These programs come with less favorable terms, so an investor who can qualify for a more traditional loan will probably want to provide traditional documentation. But when investors run out of traditional funding options, they often turn to very expensive private money sources. DSC terms tend to be far more favorable than the private money.
We’ve got options
This has been a high-level overview of an exciting segment of the mortgage world that is changing rapidly. If you are interested in more details please reach out so that we can discuss your specific circumstances and goals and vind the very best loan option for you.
Whether you are looking for a low rate on a traditional mortgage or your situation warrants a little creativity, Guaranteed Rate should be at the top of your list. Our wide array of lending resources makes us a one-stop shop. And our team of seasoned professionals will assist you with selecting the best loan option and guide you through the home buying process quickly and efficiently.
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