Case Study: Self-Employed Borrowers and Debt to Income Ratio

Brian Davis By Brian Davis

Self-employed borrowers often struggle to find financing in the secondary market. This is tied directly to the amount of income reported on their annual tax return. Most loan officers have encountered a self-employed borrower who chooses to report a lower adjusted gross income (AGI) to reduce their overall annual tax burden. By choosing to do this, borrowers can reduce their likelihood of being approved for financing in the secondary market.

In 2012, a loan officer for Simply Home Lending took an application from two self-employed borrowers seeking to refinance their home in order to lower their interest rate. These borrowers were married, owned their own business, had above average credit scores, and had plenty of equity in their home. These were very well-qualified borrowers, and the loan officer didn’t see any problems on their application until he researched their income. As is the case with other self-employed borrowers in this area, they had miscalculated the amount of their monthly income. They were not trying to mislead the loan officer; rather, they were just reporting what they believed their income to be. However, on their tax return, their AGI was much lower than what they had written on their loan application.

This situation is very common and often seen by loan officers employed at Simply Home Lending. The discrepancy is caused when the borrower and their tax preparer take advantage of the opportunity to report a lower AGI in order to reduce the amount of taxes the borrower will pay for that year. This isn’t illegal since the income is lowered by factoring business expenses into the AGI, effectively reducing the borrower’s income and decreasing their tax burden for that year.

The reason these borrowers had difficulty gaining loan approval was due to the debt-to-income (DTI) ratio of the loan. All secondary market lenders have DTI tolerances set within their loan policy, and that number will generally range from 38% to 50%. DTI is the ratio of the borrower’s monthly liabilities (car payments, credit card payments, mortgage payments, etc.) to their monthly income. For example, if a borrower and co-borrowers combined monthly income is $5,000 and their combined monthly liabilities are $2,000, their DTI ratio would be 40%. In this specific case, the borrowers initial DTI was 48.199% and the acceptable limit for the loan was 45%.

In order to gain final approval, the loan officer had to work with the borrowers to reduce their debt-to-income ratio below the 45% threshold. First, the borrowers paid off and closed two credit card accounts, which reduced their monthly liabilities by $50.00. Second, they worked with their insurance agent to reduce their homeowner’s insurance annual premium by $490.00, resulting in a reduction in their monthly liabilities of $49.22. Third, the loan officer lowered the loan amount, which pushed the borrower’s DTI below the 45% threshold. They were then given final loan approval and the loan was cleared to close.

In speaking with the loan officer about this case, he expressed how difficult it was to gain final loan approval. The debt-to-income issues presented by these self-employed borrowers are not uncommon, and luckily the borrowers in this case were very patient. They were willing to cooperate with their loan officer to find a resolution to their DTI problem and an overall reduction in their house payment of over $600.00 per month. In the end, they were satisfied with their new loan and very pleased with the service they had received from their Simply Home Lending loan officer.

From the above example, it is clear to see that the best way for self-employed borrowers to avoid DTI issues is education. It is recommended that borrowers become educated on the issues that can arise when they choose to report a lower adjusted gross income on their tax return. This is often a double-edged sword because the borrower may have to pay more in annual income tax. Nevertheless, when self-employed borrowers are well informed about DTI issues, they can make better decisions and avoid future problems.

If you have any questions about the content of this article, or would like more information on the mortgage products available from Simply Home Lending, Inc., please contact Brian Davis at 479-695-3832 or