Before the housing market collapsed, the Center for Responsible Lending recognized stated income loans as one of the biggest threats to the housing market. Unfortunately, by the time stated income loans were recognized as a threat, they had already damaged the lending marketplace. As real estate prices fell, defaults on these mortgagesrose.
Following the collapse of the housing bubble, banks stopped issuing stated income loans. They were simply too risky for banks to issue, and banks couldn’t sell undocumented mortgages in the secondary marketplace.
Variable incomes combined with tough documentation requirements make traditional mortgages difficult to obtain for some self-employed borrowers. Today, alternative documentation loans, called bank statement loans, are taking the place of the stated income loans of a decade ago.
Bank statement loans are loans where lenders use bank statements, rather than tax documents, to analyze a borrower’s income. Non-QM lenders working with self-employed borrowers will analyze 12 to 24 months of bank statements to determine a self-employed person’s net income. Each lender uses a slightly different formula to determine a borrower’s net income. In most cases, the net income reflects a person’s income after paying work-related expenses and taxes.
To qualify for a bank statement loan, a borrower typically needs at least two years of experience and income as a self-employed person.
Although the documentation standards differ from traditional lenders, Hutchens told LendingTree “these aren’t liar loans or low-quality loans.”
“We’re documenting everything, and we really know about the borrower’s ability to repay,” he said.
After determining a borrower’s income, lenders determine the maximum loan size based on a ratio of debt to income. The debt-to-income ratio is the percentage of a borrower’s monthly income that could go towards a mortgage and other forms of debt.
Traditional mortgages generally limit debt-to-income ratios to between 36% to 45%, depending on a borrower’s credit score and the size of their down payment. Bank statement lenders may allow borrowers to take on loans with debt-to-income ratios up to 55%, though the actual ratio will depend on the lender and a borrower’s other characteristics.
Bank statement loans allow borrowers to direct a larger portion of their income towards their mortgages, but these loans also require larger down payments. Borrowers with a great credit history may be able to purchase a house with a 10% down payment, but lenders may look for even larger down payments in some cases. By comparison, traditional mortgages allow down payments as low as 3%.
Despite the higher down payment requirements, interest rates on bank statement loans are often 1% to 2% higher than interest rates on traditional mortgages, according to Hutchens. Still, the interest rate gap between traditional and alternative documentation loans has narrowed over the last year. If the trend continues, interest rates on bank statement loans could soon be comparable to interest rates on traditionally underwritten mortgages.
Another group that stands to benefit from alternative documentation methods are real estate investors. The law that governs income documentation only applies to mortgages for owner-occupied housing. That means that real estate investors may be able to take on mortgages for investment properties without providing any income documentation. Instead, select lenders will underwrite mortgages based on the expected income from the property.
Stated income loans may be a financial product of the past, but new innovations in underwriting may help self-employed people and investors take out mortgages.
Products that use “alternative” underwriting standards carry higher interest rates than traditional mortgages, but for the right person, these loans make a lot of sense. Self-employed borrowers can find a uniquely tailored loan that carries the same consumer protections as other loans. Meanwhile, investors can find loans to buy properties that they couldn’t finance based on their income alone.
Whether investors or self-employed, borrowers should be careful to understand their mortgages, and compare rates from multiple lenders before choosing a loan.