Few small business owners are applying for home loans, however, it is possible for self-employed individuals to increase their chances of qualifying for a loan.
In the height of the property boom in 2007, around 24 percent of new home loan applications were received from applicants who generate income from their own businesses, explains Ewald Kellerman, head of sales at FNB Home Loans.
In the height of the property boom in 2007, around 24 percent of new home loan applications were received from applicants who generate income from their own businesses, explains Ewald Kellerman, head of sales at FNB Home Loans.
Such applications where “self-employed” individuals are party to the proposed loan have proportionately halved to just over 12 percent of new applications submitted in recent years, indicating a significant change in the home loans environment.
Even though these figures are based on applications submitted to FNB, the constant and representative market share of FNB suggests that the figure is reflective of a larger trend in new home loan applications for small business owners, he points out.
This trend could further help quantify the financial strain that small businesses have undergone since the 2008 recession.
However, even though the number of home loan applications for self-employed applicants are decreasing, the average bond size of these applications is more than 40 percent higher than that of their salaried counterparts on average, suggesting that there is a favourable upside and a healthy risk/return trade-off for potential homeowners who decide to leave the confines of employment to generate income out of their own businesses.
Complexities of lending to self-employed individuals
Kellerman says assessing a self-employed individual for home finance is significantly different and much more complex than assessing a salaried individual for the same loan.
In both instances, the bank considers three factors when a customer applies for a new home loan. They are affordability, credit history and the value of the property.
The latter two are completed on the same basis, however, the assessment of affordability separates these into defined categories, he says.
Firstly, the variability of income could severely affect the ability of an applicant to meet his home loan repayments.
“As a responsible lender we need to ensure that the potential homeowner can afford the monthly commitment in good and bad months,” he says.
As a departure point for the assessment of affordability, the bank typically calls for the annual financial statements or management accounts for the small business.
However, even though the number of home loan applications for self-employed applicants are decreasing, the average bond size of these applications is more than 40 percent higher than that of their salaried counterparts on average, suggesting that there is a favourable upside and a healthy risk/return trade-off for potential homeowners who decide to leave the confines of employment to generate income out of their own businesses.
It is not uncommon that certain personal costs are run through a small business in an attempt to reduce the tax burden. It is therefore up to the bank to identify these personal expenses and non-cash items to determine the true level of income and cash flow that the business generates, which could easily become complex.
An example of information that is difficult to disseminate from the financial statements: Many company owners group their own salary under the ‘Salaries and Wages’ in the income statement.
As a result the bank cannot determine what part of this expense is for employee salaries and that of the director’s remuneration, and result in the bank not being able to determine the true cash flow of the business.
Business owners tend to pay themselves only an amount that is necessary to meet their needs.
This could be significantly less than what the person intends to draw when the loan is granted.
In submission of the application, an applicant needs to make provision for the additional amount to cover the proposed loan instalment, which needs to be supported by the cash generating ability of the business, explains Kellerman.
The ability of the business to generate income has to be assessed independent of the personal expenses and the withholding of income will have a negative impact on the outcome.
A “free cash flow analysis” is a typical way for a bank to determine what the owner can afford to draw.
Alternatively, IT34 personal income tax returns may be accepted as proof of income for sole proprietors.
Assuming that the declared income is supported by the assessment of the cash generating ability of the business, affordability is then be determined by subtracting the declared expenses from the net declared income.
Whatever surplus is available is used to determine the amount of the loan that the customer can afford.
Finally, the history of an applicant’s conduct of banking accounts and accounts with other credit providers, as well as the security value of the property is taken into consideration when determining the final loan amount.
As a result of these practicalities, employees of small businesses often have a higher chance of approval for home loans than their employers, according to Kellerman.
In contrast to the business owner, an employee receives a payslip with corresponding deposits into their bank accounts.
When the business does poorly in any given month, employees are usually paid before the business owner can draw his or her own salary.
The combination of the risk that the owner takes and the complexities of the assessment may result in a negative outcome.
The assessment process for these “self-employed” applications is complex, and it is possible that financial information may be interpreted in a way that disadvantages the applicant if all the relevant information is not disclosed at application stage.
It is therefore advisable that small business owners speak to their business bankers directly when applying for a new home loan, who should be in a better position to understand their business and banking relationship, he adds.
Print
