Mortgage Professor: Independent contractors denied mortgages
Q. I started a business last year, and while a number of people are helping me in various capacities, I have no employees. The two people who work closely with me on a continuing basis are partners, and all the others are independent contractors retained to do specific tasks for a specific amount of money.
At the end of the year, I send them (and the IRS) a 1099, which is the official form used to evidence contract-based income. I have never sent out a W-2, which is the form that goes to employees, and never intend to.
Because I have no employees, I am not an employer, which means that I avoid having to withhold and pay employee income taxes due the federal, state and perhaps local governments. I also avoid employer taxes, including Social Security, Medicare and federal and state unemployment taxes. I don't have to provide my partners and independent contractors with equipment, office space, medical insurance, life and disability insurance, pension plans, vacation days or sick days.
A. According to the Bureau of Labor Statistics, there were 10.3 million independent contractors in the U.S. in 2005, comprising 7.4 percent of the labor force. This seems to be the most recent data available. Considering the increasing burdens we place on employers, it appears very plausible that the relative importance of independent contractors is substantially higher today. On the day I sat down to write this, a large bakery in Philadelphia announced it was converting its drivers into independent contractors.
Independent contractors have the advantage of flexibility and independence; they can work for whomever they like, but they lose the security and stability associated with employment. In addition, independent contractors have always been disadvantaged in qualifying for a mortgage, and recently this has taken a marked turn for the worst.
It has always been the case that employees were qualified based on their gross income, while independent contractors were qualified based on their net income — all business expenses are deducted from the income used to qualify. The maximum ratios of housing expense to income, however, are the same for the two groups. I am not aware of a defensible rationale for this difference in treatment.
Worse, in the current market, many independent contractors find it impossible to qualify at all. This reflects stupid turns in federal housing policies in the aftermath of the financial crisis. Following is the unfortunate position one woman found herself in after being reclassified as an independent contractor:
Q. "I was approved for a home loan of $500,000 based on 20 percent down, a 740 credit score, and adequate income that had been verified by the lender. Then all of a sudden the approval turned into disapproval. The firm where I worked for six years was acquired by another firm, and this firm shifted many employees, including me, from W-2 status to 1099. My pay is the same, so why am I being taken advantage of?"
A. Mortgage lenders don't take advantage of borrowers by rejecting them, as they make no money on rejected loans. What happened was this borrower suddenly became an independent contractor, which made her income record as an employee irrelevant. To qualify now, she must document two years of income as an independent contractor. Because the episode occurred in June, and because income as an independent contractor must be documented with annual tax returns, this borrower has to wait 2.5 years before she can qualify.
It wasn't always this way. Over several decades ending in 2007, underwriting rules became progressively more flexible in balancing one rule against another. The disappointed borrower quoted above, with good credit and a down payment of 20 percent, would have qualified under one of several "alternative documentation" provisions, paying a modest interest-rate penalty for the privilege.
Because such provisions were grossly abused during the bubble period preceding the crisis, all of them were eliminated in a mindless frenzy of rule tightening. If the cardinal sin of the bubble period was providing credit to the hopelessly unqualified, the cardinal sin today is denying credit to the well-qualified — most of whom are independent contractors. They are the "disadvantaged group" of the post-crisis era, and their numbers are growing rapidly.
• Contact Jack Guttentag via his website at mtgprofessor.com.
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