Self-Employed and Rental Income DTI Squeeze
A loan originator is prequalifying a borrower for a $400,000 conventional loan with 10% down. The borrower is a sole proprietor. Her 2023 Schedule C shows net profit of $72,000 and depreciation of $8,000; her 2024 Schedule C shows net profit of $84,000 and depreciation of $8,000. She also owns a rental condo that generated gross rents of $24,000 last year; operating expenses excluding depreciation and mortgage payments were $7,200; depreciation was $6,000; annual PITI is $13,200. The borrower has a $350 car lease, a $95 credit card minimum, and a student loan in income-based repayment with a $45,000 balance and a $0 monthly payment. Proposed PITI on the new home is $2,650. The AUS returns an Approve/Eligible with a 45% DTI threshold; the lender's overlay caps DTI at 43% unless there are compensating factors.
1. Calculate the borrower's qualifying monthly income from self-employment and rental income. State each step.
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Self-employment income: add back non-cash depreciation to each year's Schedule C net profit. 2023: $72,000 + $8,000 = $80,000. 2024: $84,000 + $8,000 = $92,000. Average the two years: ($80,000 + $92,000) / 2 = $86,000 per year, or $7,166.67 per month. Rental income: start with gross rents of $24,000, subtract operating expenses of $7,200 and PITI of $13,200, which gives $3,600 before considering depreciation. Depreciation of $6,000 is non-cash, so add it back: $3,600 + $6,000 = $9,600? No: the correct cash-flow presentation is net income after depreciation, then add back depreciation. Net income after all expenses is $24,000 - $7,200 - $6,000 - $13,200 = -$2,400. Add back depreciation of $6,000 = $3,600 per year, or $300 per month. Total qualifying income is about $7,467 per month.
2. Calculate the back-end DTI using the student-loan treatment for a $0 income-based payment, and assess whether the file meets the lender overlay.
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Debts: car lease $350, credit card minimum $95, and student loan. Because the documented income-based payment is $0, the conventional guideline generally requires using 1% of the outstanding balance: 1% of $45,000 = $450 per month. Total monthly debts are $350 + $95 + $450 = $895. Add proposed PITI of $2,650 for total monthly obligations of $3,545. Divide by qualifying income of $7,467: $3,545 / $7,467 = 47.5%. That exceeds both the AUS threshold of 45% and the lender overlay of 43%. The file does not meet the overlay as structured. The loan originator should not simply use the $0 payment to lower DTI; that would understate the obligation and conflict with the guideline.
3. What options should the loan originator explore before submitting the file, and what compensating factors would matter?
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The loan originator should first verify the income calculation with tax transcripts and the rental property's Schedule E, because the DTI is close enough that documentation errors matter. Then explore structural fixes: reduce the loan amount or increase down payment, pay off or pay down the student loan to lower the imputed payment, or reduce other debt. If the borrower has reserves, a long employment history, or a low payment shock, those may be compensating factors, but the lender overlay says 43% unless compensating factors are documented and accepted. The loan originator should not submit an inaccurate DTI or omit the student loan. If the file cannot meet the overlay, the honest options are a different product, a smaller loan, or a denial with adverse-action notice.