The Self-Employed Borrower with Declining Income

Key concerns:

1. Declining income: Year 2 net profit dropped 31% from Year 1. Lenders typically require a stable or increasing income history. A significant decline may indicate business instability. Even if the decline is due to a one-time expense, the underwriter must analyze whether the expense is truly non-recurring and whether the business can recover.
2. Use of average income: Averaging two years is common, but when there is a substantial decline, the lender may require additional analysis. Fannie Mae guidelines (for conventional loans) allow averaging if the decline is due to a one-time event, but the underwriter must document the reason and assess the likelihood of recurrence. The loan officer's argument that the business is established is not sufficient; the underwriter must verify the nature of the expense.
3. Cash-out refinance risk: The loan is a cash-out refinance, which increases the loan balance and risk. The equity position is strong (LTV 67%), but income stability is still critical for repayment.
4. Bank statement deposits: The deposits align with the lower Year 2 income, supporting the decline. This raises questions about whether Year 1 income was inflated or if Year 2 is the new normal.
5. Loan officer pressure: The loan officer's pressure to approve based on customer loyalty and equity is inappropriate. Underwriting must be based on objective criteria, not personal relationships.
6. Documentation: Need to obtain a letter of explanation from the borrower regarding the one-time expense, and possibly a profit-and-loss statement for the current year to assess trend. Also, verify the expense was truly non-recurring (e.g., insurance claim, receipt).

Proceed as follows:

1. Request additional documentation:
   • A signed letter of explanation from the borrower detailing the equipment repair, including invoices and proof of payment.
   • A year-to-date profit and loss statement (YTD P&L) and balance sheet for the business, to assess current income trend.
   • Business bank statements for the last 3-6 months to verify deposits and expenses.
   • If available, a current contract or pipeline of future work to demonstrate stability.
2. Analyze the one-time expense: Determine if the repair was truly non-recurring (e.g., equipment replacement due to accident) and whether it will affect future income. If the expense is non-recurring, it may be added back to income for qualifying purposes, but only with strong documentation.
3. Re-calculate income: If the expense is verified as non-recurring, you might use a 24-month average that includes an adjustment. Otherwise, use the lower Year 2 income to calculate DTI. With $90,000 income, DTI would be higher (approximately 60%), which may disqualify the loan.
4. Consider compensating factors: Strong equity (33%) and good credit score (720) are positive, but DTI is a key risk factor. Lenders may allow higher DTI with compensating factors, but the decline must be resolved.
5. Document your decision: If you deny the loan, provide specific reasons based on income instability and DTI. If you approve, document how you resolved the income concern and why the loan is safe.
6. Address the loan officer's pressure: Remind the loan officer that underwriting decisions must be based on guidelines and evidence, not personal relationships. If pressure continues, escalate to management.

Ultimately, the decision should be based on whether the borrower can reasonably repay the loan. Given the significant income decline and the cash-out nature, I would likely require the additional documentation and, if the decline is not satisfactorily explained, deny the loan or reduce the loan amount.