For self-employed borrowers, working out borrowing capacity can be more complicated than looking at the salary going into a personal bank account.
A business owner might pay themselves $120,000 a year while the business is producing significantly more profit behind that.
Another borrower may receive income through a company, trust distributions or a combination of different entities.
The important point is that lenders do not all assess this income in the same way.
How Do Banks Assess Self-Employed Income?
For a PAYG employee, the starting point is usually relatively straightforward.
For someone who is self-employed, the lender may need to look at the wider business position.
Depending on the structure, this can include:
- Salary or director wages
- Company profit
- Trust distributions
- Retained earnings
- Business expenses and possible add-backs
- Ownership percentage
- Business debts and commitments
- How long the business has been trading
- Whether recent income is likely to continue
The key is understanding where the income sits and how much of it a particular lender is prepared to use.
Your Salary May Only Tell Part of the Story
A business owner may deliberately pay themselves a salary that makes sense for the business rather than distributing all available profit personally.
For example, someone might pay themselves $120,000 a year while the company produces another $200,000 or $300,000 in profit.
If a lender looks only at the salary, the borrowing result may not reflect the wider financial position of the business.
Some lenders may be prepared to consider additional company profit where the borrower has sufficient ownership and the business financials support it.
Others may take a more conservative approach.
That difference can have a significant impact on borrowing capacity.
Can a Bank Use Company Profit?
In some cases, yes.
The lender will usually want to understand whether the profit is genuinely available and sustainable before including it in the assessment.
That can involve looking at:
- The borrower’s ownership percentage
- Whether the profit is recurring
- The business’s working capital requirements
- Existing business debts
- Whether there have been unusual or one-off results
- Whether the business has been consistently profitable
A strong profit figure does not automatically mean every dollar can be added to personal income for lending purposes.
The lender still needs to be comfortable that the business can support the income being used.
What About Retained Profit?
Retained profit is another area where lender policy can vary.
A business owner may leave a meaningful amount of profit inside the company rather than distributing everything personally.
Depending on the ownership structure and lender policy, some lenders may be prepared to consider part of that retained profit when assessing borrowing capacity.
Others may not use it at all.
This is why the income shown on a personal tax return does not always tell the full story for a self-employed borrower.
How Do Lenders Treat Trust Distributions?
Trust structures are common with self-employed borrowers and can add another layer to the assessment.
Income may be distributed through a family trust or between different beneficiaries.
The lender may want to understand:
- Where the underlying income is generated
- Who controls the trust
- Who receives the distributions
- Whether the income is recurring
- Whether the borrower has access to or control over the income being relied upon
A trust distribution appearing on a tax return does not automatically mean every lender will use it in the same way.
Some lenders may be comfortable with the structure, while others may require additional information before including the income.
Can Add-Backs Increase Usable Income?
Business financials can contain expenses that reduce taxable profit but may, in some circumstances, be added back when a lender calculates usable income.
Depending on the lender and circumstances, these may include items such as:
- Depreciation
- Interest expenses
- Genuine one-off costs
- Certain non-recurring expenses
- Other items the lender is satisfied do not represent an ongoing cost to the business
Not every expense can be added back, and different lenders can take different approaches.
This is one of the reasons the detail within the financial statements can matter just as much as the headline taxable profit figure.
Do You Always Need Two Years of Financials?
Not necessarily.
Two years of financial statements and tax returns are still commonly requested, particularly where the lender wants to establish a consistent trading history.
However, there are lenders that may consider one year of financials in suitable circumstances.
This can be particularly useful where a business has grown strongly or where an older financial year no longer reflects the current position.
For example, if business profit has increased from $180,000 to $320,000, the lender may want to understand what caused the increase and whether it is likely to continue.
That could include factors such as a new contract, increased staff, improved margins, business expansion or another identifiable change.
The stronger the explanation behind the numbers, the easier it is for a lender to understand the current position.
Taxable Income and Borrowing Capacity Do Not Always Move Together
Business owners and their accountants may quite reasonably look for legitimate ways to manage the tax position of the business.
Lenders, however, often rely on taxable income and business profit when calculating borrowing capacity.
This means a lower taxable income can sometimes also reduce the income a lender is prepared to use.
That does not mean business or tax decisions should be made purely to obtain a home loan.
Tax and business-structure decisions should be discussed with an accountant or appropriately qualified adviser.
From a lending perspective, however, it is worth understanding how those decisions may affect borrowing capacity if a property purchase or refinance is planned in the next year or two.
Related: Changed Your Business Structure? What It Can Mean for Your Borrowing Capacity.
Why Lender Choice Can Matter More for Self-Employed Borrowers
For a straightforward salaried borrower, a number of lenders may produce fairly similar borrowing results.
For self-employed borrowers, the gap can be much wider.
One lender may be comfortable using company profit while another may take a more conservative approach.
One may accept a single year of financials in the right circumstances while another may require two.
Another may have a more suitable policy for retained profit, trust income or the way the business is structured.
This is why choosing a lender based only on the advertised interest rate can be limiting for a self-employed borrower.
The lender also needs to suit the way the income is actually earned.
What If the Latest Financials Are Not Ready?
Sometimes a business is trading well but the latest tax returns or financial statements have not yet been completed.
That does not always mean the lending needs to wait.
Depending on the situation, an Alt Doc lender may be able to assess income using other evidence such as BAS, business bank statements or an accountant’s declaration.
Alt Doc lending is not the same as having no documentation. The lender still needs to assess whether the income is reasonable and whether the business can support the proposed lending.
In some situations, this may provide a shorter-term solution, with the lending reviewed again once full financials are available and a mainstream option becomes possible.
Related: Alt Doc Lending for Self-Employed Borrowers: When Can It Be Useful?
Start With the Business Structure, Not the Application
Before comparing lenders, it helps to understand the business itself.
That means looking at how the business is structured, who owns it, where the profit sits, how income is paid to the borrower, whether trusts or other entities are involved and what financial information is currently available.
Once that position is clear, it becomes much easier to identify which lenders are likely to assess the income appropriately.
That is generally a better approach than submitting an application first and trying to explain a complicated business structure afterwards.
Have a Question About Self-Employed Borrowing Capacity?
Self-employed income can be assessed very differently depending on the business structure, available financials and lender policy.
Ask me a question if there is something about your business income or borrowing capacity you would like clarified from a lending perspective.