How do Profit and Loss Mortgage Loans function
Core Purpose and Ability-to-Repay (ATR) Assessment
How do Profit and Loss Mortgage Loans function?
The central function of a P&L mortgage loan is to provide a comprehensive, verifiable method for determining a self-employed borrower’s ability to repay the mortgage debt, independent of their tax-reported income.
- Non-QM Classification: P&L Statement Only loans are categorized as Non-QM loans, which means they do not comply with all the strict criteria of Qualified Mortgages (QM). They are a valuable option for creditworthy borrowers, including self-employed individuals and gig economy workers, who cannot secure financing through standard government or GSE channels.
- Ability to Repay (ATR): Despite being Non-QM, these loans are subject to the Ability-to-Repay (ATR) rule imposed by the Dodd-Frank Act. The P&L statement serves as the core documentation for us to make a good-faith effort to determine the applicant’s capacity to repay the mortgage.
- Underwriting Methodology: The underwriting of P&L income often requires a manual review. For self-employment income calculation, we are typically instructed to use the Fannie Mae Cash Flow Analysis (Form 1084) or an equivalent.
Required Documentation and Verification
P&L loans rely on stringent third-party preparation and verification to establish credibility:
- Preparer Requirements: The P&L statement must be prepared by a Third Party Certified Public Account (CPA), an IRS Enrolled Agent (EA), or a CTEC registered tax preparer (PTIN).
- Ineligible Preparation: Statements prepared by the borrower are not permitted under any circumstances. Additionally, self-employed borrowers who file their own tax returns are often not eligible for the P&L program.
- Documentation Timeliness and Certification:
- P&L statements must be signed by both the borrower and the tax preparer.
- The P&L end date must be less than 90 days old at closing.
- The CPA/EA/CTEC preparing the P&L must often attest to having prepared the borrower’s most recent tax returns.
- We must verify the CPA/CTEC license is active.
- Business History: The borrower must document they have been self-employed for at least two years in the current business to qualify for the P&L program. This can be verified via a business license, letter from the tax professional, or Secretary of State Filing.
Income Calculation Function
The P&L statement functions to calculate the borrower’s stable monthly income by factoring in business expenses and ownership share.
- Core Calculation: Qualifying income is the monthly net income from the P&L statement, divided by the number of months covered by the statement, and then multiplied by the borrower’s ownership percentage.
- Qualifying Cap: The resulting qualifying income is the lower of the P&L net income or the monthly income disclosed on the initial signed 1003.
- Expense Factor/Floor: We impose minimum expense floors to ensure the net income figure is realistic:
- For our Horizon (P&L Plus 2 Months Bank Statements), if expenses are less than 20% of gross revenue, the net income will be adjusted to reflect a 20% expense level when qualifying.
- For Nations Direct Mortgage (P&L Only), the minimum expense factor is 20% for service-related business and 40% for product-based business.
- For our Sharp, businesses with less than a 15% expense ratio will be limited to a 15% ratio.
- Add-Backs for Cash Flow: Certain expenses listed on the P&L that do not represent actual cash outlay may be added back to the net income, including depreciation, depletion, and amortization/casualty losses.
P&L Statement in Context of Other Alt Doc Loans
The P&L statement is also used to function alongside other alternative documentation methods:
- Bank Statement Validation: For Bank Statement loans, a P&L statement prepared by a qualified third party is sometimes used to validate the gross receipts. For our Connect, the deposits on the business bank statements must support at least 75% of the gross receipts listed on the P&L.
- Asset Depletion Loans: P&L loans are distinct from Asset Depletion Loans, which function by leveraging a borrower’s liquid assets (investments, savings, retirement funds) to calculate qualifying income, primarily serving retirees or high-asset, low-income borrowers.
Associated Risks and Loan Features
P&L loans function within the higher risk framework of Non-QM lending, requiring compensating factors:
- Risk Premium: To offset the risk associated with limited documentation, P&L loans typically carry higher interest rates than traditional QM loans.
- Credit/LTV: We focus on borrowers with higher credit scores and lower Loan-to-Value (LTV) ratios to balance the risks of limited documentation.
- Flexible Terms: P&L loans may incorporate features prohibited by QM rules, such as interest-only payments or terms longer than 30 years (e.g., 40-year fixed IO).
- Eligible Transactions: P&L documentation is eligible for purchase, Rate/Term Refinance, and Cash-Out Refinance transactions. Cash-Out Refinances allow up to $500,000 max cash-out in some programs.
FAQ's
As Non-QM loans, they may offer features prohibited by QM rules, such as loan terms longer than 30 years (e.g., 40-year fixed terms) or Interest-Only (I/O) payment features.
Lenders generally compensate by requiring borrowers with P&L income to have higher credit scores and lower LTV ratios (larger down payments). P&L programs often require a minimum FICO of 660 or higher.
While QM loans are capped at 43% DTI, P&L (Alt Doc) loans often allow a higher DTI, typically capping around 50%.
The P&L end date must generally be less than 90 days old at closing. Some programs require it to be less than 60 days old at closing.
The calculated qualifying income is limited to the lower of the net income derived from the P&L or the monthly income disclosed on the initial signed 1003 (loan application).
It must be prepared by a Third Party Certified Public Accountant (CPA), an Enrolled Agent (EA), or a CTEC registered tax preparer (PTIN). A borrower-prepared P&L is not permitted.
The loan functions by allowing certain non-cash business expenses, such as depreciation, depletion, and amortization/casualty losses, to be added back to the applicant’s income for qualification purposes.
Underwriting requires a manual review, utilizing the Fannie Mae Cash Flow Analysis (Form 1084) or equivalent for self-employment income calculation.
The loan file must document the borrower’s Ability to Repay (ATR) the mortgage debt, a mandate imposed by the Dodd-Frank Act.
P&L loans use alternative documentation such as a Profit and Loss statement prepared by a third party to understand the borrower’s financial situation.
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