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Hey, welcome to Seller Finance and Creative Deals podcast. I'm Dan Depen and today I'm going to be talking about evaluating self employed borrowers. And in the world of seller finance this is something that causes a lot of confusion. So some people think a W2 is required or a lot of times people run into borrowers with all sorts of different types of income. So today I'm going to talk about how this whole business of documenting self employed income works, the range of options you have, what we look for, what's not going to work and all those other kinds of things. So hopefully this will clear up a lot of misconceptions or just fill in a lot of blank spots for a lot of folks. And it's something that in the last gosh, coming up on two years, over a year and a half that I've owned called the Underwriter, we've really improved our processes on and looking at. So I know like when I started like there was one in particular, couple files in particular from a guy that was doing a lot of mobile home loans and they would send in these like random bank statements and there would be a lot of tail chasing like trying to figure out how to do it. Today we've got a pretty well baked process that we can get through fairly quickly and is based on what a lot of the large wholesale lenders are doing in the non QM lending world. So okay, so starting off kind of at the beginning. So why do we even need to verify income of a borrower and granted to level set? I'm talking specifically about the case where you're originating a seller finance loan and the borrower is going to be be an owner occupant. Right. So it could just be a straight seller finance deal where you're selling a property one free and clear, could be creating a wrap loan. That end of it doesn't really matter for this if you're creating a new loan for a borrower, they're an owner occupant, we have to comply with Dodd Frank one of the eight or it kind of muddles into a couple of them. But Dodd Frank has eight elements of the ability to repay. And one of the things we got is verify the borrower's income so we can calculate their debt to income ratio. Now you're probably familiar with the whole mess in 2008 and all the fallout from stated income loans and liar loans and that kind of thing. So they passed Dodd Frank and a number of other laws that basically say if you're creating a loan for an owner occupant, you got to validate how much income the borrower has and that they have the ability to repay the loan. So that's why this is so important as well. But here's the deal, right? Like even if that legal requirement didn't exist, like as an investor, you're creating a loan just like anything else. You want to underwrite your borrower, understand it's in your best interest to know that the borrower makes enough money to pay you. That's really just kind of common sense. The reason there was this weird period of time before the financial crisis where lenders would create loans and they didn't care if their borrowers would pay them back or not was because they had the ability to just immediately resell those loans in the secondary market. So they weren't holding the bag. So even if there wasn't a requirement to do all this, those secondary market buyers have hopefully wised up and you'd be stuck with these bad loans anyway. So it's a little bit academ. So even though, yeah, there's a compliance aspect to this, the reality is it's in your own best interest to know that your borrower can afford to make payments for you. So what the ability to repay requirements in Dodd Frank basically require you to to document is the borrower's income or the assets that you're relying on for them to repay the loan, their employment status, you know, are they employed by somebody else? Are they self employed? Are they on Social Security? Are they on VA or disability benefits? What are their other monthly debt obligations? So what's going to be their new payment on this loan? But then what other monthly debt payments do they have? Auto loans, credit cards, installment loans, student debt, all those sorts of things. And so what we're ultimately going to do with this is we're going to take the total monthly debt payments, the borrower's other loans, plus the new loan, and divide it by their gross monthly income to come up with a debt to income ratio. And that debt to income ratio is one of the things we use. It's just one to help determine whether the loan is going to be compliant or not. But it's something that investors use to kind of measure the relative risk level of the loan. And so what we want to do in our underwriting process is document what the borrower's income is, validate that, and then take that along with the other information to come up with a good debt to income ratio. This is part of what's going to go into our RMLO package at the end that shows that you've got not just a compliant loan, but a good loan as well. So, you know, if you're the vestor, obviously that's in your best interest. Or if you ever decide to sell a loan down the road or borrow against the loan, your potential loan buyer is going to care about this stuff a lot. And so it can seem like kind of a hassle. I know a lot of investors have kind of the idea of, well, as long as the borrower makes a big down payment, I'll just operate in a non judicial foreclosure state. And if I get a big enough down payment, I don't care if they pay me back or not because I'll just foreclose them out. A lot of these consumer laws are specifically designed to prevent that kind of behavior, which most attorney generals would consider a little predatory. So, so why it matters, even though it's kind of a pain in the butt? Well, for, you know, as a loan originator, you know, if you haven't really validated what income the borrower makes, this is going to become a super risky loan. And so if the loan goes bad, you start foreclosure, you're in court and the borrower pushes back and tries to claim that they could never afford the loan in the first place. If you get asked, well, did you follow Dodd Frank Validate, they have the right income. And if you go, well, I didn't really check, you know, you're going to get into rough territory there as well. And so if you're reselling the note or if you're a buyer of a seller finance note that someone else originated, you know, this information is going to tell you a lot about the relative risk level of the note. And what's great is if you're a note buyer, you know, a lot of note buyers kind of anchor on wanting a certain amount of seasoning. So they say, well, I like to see that the borrowers made six payments or 12 payments after the loans originated. But, and that's fine, there's nothing wrong with doing that. But any well originated loan, if the borrower is credit worthy and has plenty of income, you do all these other things, it's a substitute for having to wait for the seasoning. So that's why it's like super critical to have if you're going there and you're buying a loan, you ever see anybody, you know, if they ever mentioned that it was just stated income, that is like a gigantic red flag. So if somebody actually had the income, they would just document it. So this whole business of verifying the borrower's income is not some kind of like bureaucratic box checking. It's what makes sure you have a quality loan and then make sure your loan is defensible. If you ever get challenged. Now in the seller finance world, probably the majority of the borrowers we see are self employed. Okay. And there are some reasons why the conventional lending world likes to shy away from self employed borrowers. And, and I'll get into that because when we're dealing with self employed borrowers, it's, it's a lot, it can be a lot more challenging to validate income than somebody who's saying a W2. Will we ever get a borrower that's a W2 employee? I'm always jumping for joy because for us it's dirt simple to underwrite. So we're just going to get a copy of their W2 from last year, we're going to get a copy of their two most recent pay stubs to make sure that they're still employed and the incomes hopefully the same or higher level than the previous year. And it's like easy peasy, it's like a two minute thing. Likewise, if borrowers on some kind of fixed income, Social Security, VA benefits, etc. They have an award letter that shows how much they make every month. And it's dirt simple. That is what it is. But when a borrower is self employed, it's a little tricky. So by and large when a borrower is self employed, you know, they're not getting a statement necessarily from a third party saying how much they made. Right. So now in a perfect world, you know, a small business owner might come with audited financial statements from their accountant. I've never seen that once. And doing hundreds of seller finance files. But if somebody could bring that, that would be kind of the gold standard, sort of the self employed equivalent to the W2. So the way that we actually verify self employed income the majority of the time is we'll want to get their last 12 business bank statements. That allows us to see all the business transactions, mainly the deposits associated with the business going back over a year. Now we can also use their last two years tax returns. We don't do that real often because by and large, you know, mileage varies depending on the type of business that they have. But for most situations the tax return is really going to understate how much income borrower has. So for example, you know, if your self employed borrower is A real estate investor, you know, they may be claiming very large amounts of depreciation. And so how much they're actually cash flowing, you know, earning month to month versus their actual taxable income, you know, could be radically different in a lot of cases. But if you can use tax returns, it's great because, you know, if you can get them and that works, it's going to be a very conservative way to look at the income. But most of the time it doesn't pan out. Now, if they're an independent contractor working for somebody else, they get a 1099. It's pretty simple as well. We just get a 1099 form from them. But the majority of the time we're dealing with bank statements. So why do we ask for 12? Well, that gives us the most complete picture of what's been happening with the borrower over the last year. But we need 12 complete bank statements. And this is really important. What, what happens a lot is we'll make this request of borrowers and they'll send us a subset of what we asked for. So instead of 12 months, they'll send us four or five months, or instead of sending all the pages, they'll send like some of the pages or they'll send the first page. We actually need to be able to go through the whole thing and see everything that's on there to validate what's associated with the business and what's not. Now, ideally, they have a separate checking account for their business that everything runs through. That makes it easier. The reality is, a lot of times people will munge their business and business activities with their personal activities, and that creates another level of, of challenges. Right, but sometimes we do, you know, get into this, like back and forth with borrowers where we tell them exactly what we need, they send some of it, we tell them exactly what we need, they maybe send a little bit more and, and that's something gets into something. That's been a huge lesson learned for me. So at the end of last year, kind of around Christmas time, I always do a lot of reflecting on the year and I was going through a lot of the data that we have from call to underwriter. So we see hundreds of these deals every year, probably more than anyone else. And the nice thing about seeing a lot of volume is you get the opportunity to spot patterns that other people may not be, to spot, be able to spot. And one of the big things that jumped out last year is I noticed that if a borrower doesn't get us all the information that we need within about three days, then the probability of the deal falling through for one reason or another shoots through the roof. And that happens for a few reasons. One reason can be sometimes the borrower is not that serious. So if they're not under contract yet with the seller, they haven't made an earnest money deposit. You know, sometimes the investor slash seller gets kind of overly excited and thinks they have a deal when maybe they don't and the borrower just kind of ghosts or, or disappears or flakes. What's more common though is if a borrower feels, if they're worried about how their credit score is going to look or they're worried about there's going to be an income problem. We've seen that they often try to slow roll in an effort to hope that the investor is going to get anxious, trigger happy and maybe just forge ahead with the deal before all the income is documented. And you know, amongst creative financiers they're pretty aggressive, you know, moving bunch. They're not ones to sit around. So it's maybe not the worst strategy and the world from the borrower standpoint but generally if you've got a borrower, they're a good borrower. They're excited about buying the home. They know that their credit's at least reasonable. They know that they can afford to buy the house. Usually they're excited, they're going to get everything in right away. So whenever you see the borrower where you ask for 12 statements and they send five and they're not complete and then you say no, we need 12 complete and they send five but they're, or they send complete ones but only five instead of 12 and they say no, we need 12 complete ones and then they send 10. But two months are strategically missing. They're usually covering something up most of the time. So one way or another, either we're never going to get all the info we need out of them or when we do something's wrong, that's another thing I find sometimes that's kind of hilarious. Like people will leave out a month or two like in the middle of the year and then when you go back and you get those, it's usually not good. So they're, they're like trying to engineer their, their DTI to show the, you know, to pull out the months that weren't so great because you know, I fully well know as a self employed person, right, there can be a lot of variance month to month. Some months look phenomenal. Like if you multiply that by 12 you'd be like, oh my God, this is incredible. Other months not so good. So we've learned enough observing borrower behavior. We can almost do what I call like meta underwriting. In fact, a lot of times I can kind of tell how a file is going to look in terms of credit and income before actually seeing the credit report or the documentation just by observing how the borrowers behaved throughout the process. So a lot of times what they're, how they're going through this tells you a lot. So maybe somebody doesn't want to send a couple months of bank statements because they think it's going to look bad and they don't want to send that information. Well, the fact that they hold it back also gives information. It's kind of like poker. There's not really a lot of opt out whether you're sending information or not sending information. The way you're behaving is sending information all the time. And when you see enough of these, you can really lock in to that kind of stuff. So that's that. And then the other thing that's really important is the whole story really needs to add up overall. So for example, I had a, it wasn't a loan that we originated. I was actually looking at buying a loan from someone else and it was underwritten by another rmlo. And so they sent this loan to me and I said, you know, was this originated correctly use an rmlo? They said yes. And I was excited. I'm like, that's great because I might be able to buy this. Send me their, their package. Right. And in this other RMLOS package they had the income documentation and the calculations that they used. And number one, they use six months of bank statements instead of 12, which is not the end of the world in and of itself. 12 is the gold standard. There can be valid reasons for only using six. If it's a newer business or the change banks are, you know something, there can be reasons. But what happened in this file was, and the, the loan seller said, hey, this is a great borrower. Their debt to income is only like 27%. I'm like sweet. But when I looked at how they actually calculated the income in the six months that they provided bank statements for, they had about 30k in income in one month and almost no income and the other five months. So they average that out and they said, oh, their monthly income is between five and six thousand dollars and their debt to income ratio is great. Well, if we're seeing that level of scatter, we're like literally like There was just one month where There was this 30k check that showed up. That doesn't tell me that that's what that I can expect that borrower to make on an ongoing basis. And when I talk about the story adding up, you'd say, okay, fine, it's obviously super lumpy. We have six months. All the income, almost all the income came in one month. Does that fit with the kind of business that they say they have now? If the borrower was a, you know, a real estate investor, like a Fix and Flipper or something, yeah, they could have a super lumpy income. Right? Like they might have a month where a couple of deals close out and they do great and they might have a stretch of months where they're working on stuff, but things aren't paying off yet. So that could add up. But in this case, borrower said that they owned a dog kennel and I don't know how that works where a dog kennel would make exorbitant amounts of money in one month and then like almost no money in these other months. And then when I was searching for this person and this mystery dog kennel, I could not find any record of it anywhere. We do go back and check on these things as well. So it's really, it's not just the mechanical process of going through the bank statements and applying some folded formulas that I'm going to talk about in a minute. It's also just looking at all aspects of it and say, hey, how does this add up? Does the documentation and what they're saying all fit together? Does the income flow match the kind of business that they have? Is the way that the borrowers providing information indicate that, that, you know, you can take what they're saying at, at face value or not. So the story's got to add up. Now the other thing is, once we get into actually reading the bank statements, there are a number of problems we can get into. One of the things we always do. First things we do is check the name on the account. Does it match the borrower? I've seen more than one file where a borrower submits an application. They say, this is my name and then they send bank statements and like somebody else's name is on it. That's obviously a problem unless they have some documentation for why their business banking is going through this other account. Now if they do have a pure business checking account in the name of an llc, that's awesome. That's. That's better. We just want to see something saying, yeah, that's the LLC that they own. Right. So we want to make sure all of that is clean. The other thing we see a lot, it's not necessarily, it's not a showstopper issue. It's just more of a pain for us is when people commingle their business activities with their personal activities in the same account. And sometimes it's really challenging to figure out what's what. So a lot of times we end up going back to the borrower, asking them more questions about the business. Where does the income come from? Right. Like some people, their business incomes all through Zelle deposits, some of it, they do a lot of work for cash and they're depositing cash. And that brings up another good point. If a borrower is self employed and they often get paid in cash, that can be okay as long as they're running it through some sort of institution and there's some paper trail. So if somebody gets paid in cash and they deposit that cash and you can see that reflected on bank accounts and better yet, they're paying taxes on that cash, that's good to go. But every now and then we get borrowers where the lender says, hey, my borrower makes a lot of money, but the delegate get paid all in cash. They don't file taxes, they don't have a bank account that we can't do anything with because it's not documented. We can't show that we comply with Dot Frank in that case. Now if somebody uses QuickBooks or something for their business, that's ideal. Most of the ones we see do not do that. Sometimes we quite, I've quite literally before reverse engineered somebody's profit and loss statement to their last 12 bank statements, which is, you know, a fair amount of work. But that gets into what we care about is not just the income shown on the bank statements, but the expenses as well and the expense ratio of that business. Now generally the industry practices, you don't necessarily have to go through and validate every little expense. But we can use rules of thumb based on the type of business that it is. So if somebody, let's say they're just an independent contractor, they're like a consultant, right. Their expenses might be darn close to zero. Somebody who owns a landscaping business where they're, they have a lot of labor expenses and a lot of equipment, trucks and whatnot, their expense ratio is going to be far, far higher. So when we look at the actual usable income from a set of bank statements, the first thing is we start with the gross deposits and then we apply that expense ratio based on the type of business it is. If we don't know anything about it, just as a starting point, we'll default to an expense ratio of about 25%. Like I said, depending on what they're doing, it could be a lot less. It could be 60, 70%, you know, if they're running like a full construction business. And so we'll take the average of the deposits, apply the expense ratio and that's how we come up with the usable income. So to kind of try to wrap some of this stuff up. So the reason it's so important is to verify income is because one of the things we need to do, number one to comply with Dodd Frank, but probably number zero is because so you as an investor understand that your borrower can afford the loan. And so self employed is not disqualifying by any stretch of the imagination, it's just messier. Right? So that process of figuring out bank statements, figuring out an expense ratio, making sure the account matches, as you can tell, that's a heck of a lot more work than just looking at a W2 and some pay stubs. That's part of why a lot of conventional lenders shy away from it. It's not that it's even disqualifying, it's just more work and sometimes more judgment is required on the part of the underwriter. And then the third thing I really wanted to focus on was if you do see your borrower kind of slow rolling you or they're just having like weird challenges that don't make sense or they can never quite get everything, something's always kind of missing. Generally that's a red flag. It's a good idea just to talk to the borrower, see what's going on, see if you can save the deal somehow and then make sure everything adds up. Right. If the self employed borrower has lumpy income, that's not unusual at all. But make sure that fits with the kind of business they say they owned and double check that there actually is a business that exists like, like they say it does. So, so there you go. That those are my tips today and kind of discussion on how we figure out income for self employed borrowers. It's a big topic. I've spent months and months and months nerding out on this stuff and you know, building systems to where we can do this pretty quickly. But if you have more questions about that, let me know in the comments. You can always drop me an email@dan calltheunderwriter.com and we'll see you guys next time. Thanks.