Why It Can Be Difficult for Business Owners to Qualify for a Loan
Did you know that affluent or well-to-do business owners often have trouble qualifying for a mortgage?
It sounds weird, right? maybe you were not aware of this.
Income
Credit
Collateral
are the three pillars of mortgage lending, of any lending for that matter, not just mortgage lending.
In the case of the established, successful business owner, Income is usually not the problem; there is plenty of it. But most traditional lenders only look at income through the narrow lens of tax returns.
To a business owner, a tax return is a bill, therefore a savvy business owner hires a professional business CPA in order to take advantage of every single favorable and legal tax deduction to minimize his bill to Uncle Sam.
The other ingredient traditional lenders look for is credit. They usually expect to see a credit score of at least 680. The lender's definition of credit is a narrow one; they only consider the institutional credit that shows on your credit report.
This is not the credit the business owner uses or depends on.
The lender will not take into account the credit that really matters to your business: vendors, raw material suppliers, landlord, and customers.
Additionally they won't give a lot of weight in their formulas to whether or not you paid your debts off—they are more interested in how you paid them over time. This is significant to them: how you paid them over time is more important than whether or not you paid them. Because how you paid them had an influence on how much money those lenders made on those loans to you.
To a business owner, what is important is the complete reverse! The business owner focuses on paying debts off. That, to him, is the objective he wishes to accomplish!
Another perplexing aspect of institutional credit, from the point of view of the business owner, is that to have a high credit score you must not use the credit you have been given. Talk about throwing a curve!
I will never forget the case of one of my clients, an experienceed businessman who had on his credit report 40 mortgages that had been fully paid off. Simultaneously, I also had a different, younger client with only three credit cards. They were both applying for a mortgage at the same time.
Who do you think had the highest FICO score? The savvy business owner with a track record of 40 paid homes or the younger client with 3 credit cards?
Shockingly, to me, the younger client had a better credit score than the client with 40 paid homes! To my complete bewilderment, when I pointed out to the lender the 40 paid homes - it caused suspicion!
Lenders and business owners operate in opposite modes!
Business owners tend to have a lower credit score because the FICO formula does not measure business success or financial success. It measures success in debt management, and only according to very limited (lender-defined) criteria.
Successful business people are not always great at managing debt according to the standards of lenders; they are often busy and sometimes miss a credit card payment, or sometimes they have a more urgent bill that they need to pay first.
To recap: even though business owners have great income and great credit with the people they do business with, lending institutions measure income and credit using completely different standards. Therefore, (mainstream) lenders often conclude that a business owner:
doesn't have enough income
doesn’t have a high enough credit score
The only pillar of lending left to look at is Collateral.
In the case of business owners, the Collateral is usually great! They are usually buying or refinancing a high-end home or great commercial building.
When it comes to Collateral, business owners and lenders are usually on the same page!
But, loans that qualify you on collateral only are the more costly! And they are usually of short term duration. These loans are called “Hard Money Loans.”
Loans focused on Income are the cheapest, followed by loans focused on Collateral. The most costly loans focus on Credit, such as credit cards.
There is a similar parallel when it comes to the difficulty in getting approved for loans:
Income-Focused Loans require the most work and in general, are more difficult to qualify for
Collateral-Focused Loans take less work and are easier to qualify for
Credit-Focused Loans can be approved with minimal work & great speed
Of these three categories of loans, the longest terms are found in Income-Focused loans, with 10 to 30 years to repay. Collateral loans generally give you 1 to 3 years to repay them. And Credit-Focused loans can be terminated, frozen or cancelled at any time (such as credit cards).
Fortunately, business owners do have options when it comes to mortgage loans.
Specialized lenders provide loans that cater to business owners and self-employed professionals, that do not require tax returns.
The bank statement loan is one variation of these so-called “alternative documentation” loans. Instead of tax returns, the business owner provides bank statements for his business, going back over a certain period of time. These bank statements are analyzed by special software and the real income is extracted from them. The lender uses this as proof of the applicant’s income (other qualifications, such as a certain level of credit score, also still apply).
Another variation is the Profit & Loss loan. The business owner provides a Profit & Loss statement for his business, signed and dated by a licensed accounting professional (this can be a CPA, Tax Preparer or Enrolled Agent). The accounting professional also provides a letter stating certain basic information about your business. To qualify for this type of loan, you need to have a credit score of 680 or more, and some other items have to be in place, including an up-to-date corporate structure with business licenses active and up-to-date. But this type of loan does not require you to provide lengthy bank statements or any other type of income documentation. As a result, loans can be completed in as little as three weeks!
Another variation of alternative documentation is the Asset-Based Loan. With this loan, you need to prove that you have liquid assets (such as money in your bank account or stocks that can be easily converted into cash) amounting to the purchase price plus the closing costs, plus $1. If you can prove this, no other income documentation is required. We will take an in-depth look at the Asset-Based Loan in a future article.
And there are other still other ways of qualifying as well!
Please note that “alternative documentation” loans have a slightly higher interest rate than “regular” tax-return based loans. Of the alternative documentation loans, bank statement loans tend to have the lowest rates (but still higher than tax return loans), and Profit & Loss Based Loans and Asset-Based Loans have a slightly higher rate than bank statement loans.
All of these loans have their place, and each of these loans can make a lot of sense (or no sense) depending on the specific scenario at hand.
We specialize in mortgages for business owners and self-employed professionals. We are used to dealing with complex loan scenarios and multiple income streams. If you would like to go over your specific loan scenario and run some numbers as to what could make sense for you (without any presssure), you can schedule an appointment here.
