Home loans: how banks assess the self-employer
The stringent credit criteria applicable to self-employed individuals, coupled with bad accounting practices, have made it difficult for the self-employed to obtain a home loan.
A total of 11 425 companies and close corporations were liquidated in the period 2008 to 2010. In the same time (but excluding December 2010), a total of 13 859 individuals and partnerships became insolvent, according to Luke Doig, the senior manager of Credit Guarantee Insurance Corp of Africa.
“The number of individuals affected by the 2008 financial crisis and resultant recession was quite severe,” Doig says.
When you look at these statistics, you can understand why the banks have become extra cautious when assessing the financial statements of self-employed individuals.
If you own 25 percent or more of your company, you are considered by most banks – for the purpose of obtaining a home loan – to be self-employed, and the banks will request the financial statements of your company. (The percentage may vary; see Standard Bank’s response below.)
Property Factor, which specialises in procuring finance for this category of home buyer, often comes across financial statements that either have been drawn up incorrectly or are not a true reflection of the financial position of the enterprise. Entrepreneurs are the creative minds behind their organisations, but they often do not pay attention to, or do not understand, their financial statements.
While the profitability of the company is important, it is the balance sheet that completes the picture. The banks will look at the liquidity of the company by comparing the total current liabilities with the total current assets. Ideally, for a company to be in a healthy, liquid position, the current assets must be double the current liabilities. Should the current assets be less than the current liabilities, the company will be considered illiquid. It will be difficult to raise finance under such circumstances.
Gearing is the measure of the degree to which a company’s activities are financed by debt (long-term liabilities) or the owner (capital employed/owner’s equity). The higher the gearing, the higher the risk, because the company will need to continue servicing its debt irrespective of a drop in turnover.
Other items in the balance sheet will be scrutinised with the following questions in mind:
* Shareholder’s/member’s loans. Is the owner required to fund the enterprise year-on-year or is it self-sustaining?
* Is there long-term tax liability outstanding?
* Is stock being replenished or is it being depleted?
* Is the business cash flow positive or negative?
In the income statement, the following will be subject to scrutiny:
* Turnover. The bank will look at whether the year-on-year turnover is increasing or decreasing. A decrease in turnover will have to be motivated.
* Cost of sales as a percentage of turnover.
* Depreciation. At times, depreciation, which is not a cash-flow item, may be added back to the company’s net profit. However, this can be done only if all the assets have been fully repaid and there is not a liability outstanding on these assets.
* Remuneration of members/directors. This must be shown separately and not included in staff salaries. The salaries declared will be compared with the deposits made into personal bank statements of the members/directors.
All declarations made in the financial statements and by accountants will be compared with what is actually reflected in the business and personal bank accounts. Any huge discrepancies will require some explanation. Alternatively, the banks reserve the right to call on tax returns for both the applicant and the organisation.
While the banks seldom approve an application based on the figures in management accounts, they will call on them as well. Management accounts are a record of all trading activities of the organisation, whether of a capital or an income and expense nature, from the beginning of the current financial year. They must not be older than two months.
Management accounts are similar to financial statements, it is just that they have not been audited or signed off. They are used by the banks to confirm that, since the previous financial year end, the business has remained profitable and sustainable, and turnover has not dropped drastically.
They are also a reflection that the entrepreneur is in control of the financial aspects of the business and knows where it is heading.
When procuring home-loan finance for self-employed individuals, a professional with a thorough understanding of accounting practices is required. More often than not, your bond broker will have to arrange a meeting with you and your accountant in order to obtain a better understanding of the business, and then position the application correctly for a positive outcome.
Gone are the days that completing an application, supported by an income letter from an accountant, would suffice.
Absa says it has nothing to add to this analysis, and Nedbank did not send a response when asked to do so. The other two large retail banks, First National Bank (FNB) and Standard Bank, had some pointers to add.
The first thing FNB looks at is the credit record of the owners (directors) of the business, after which it does credit checks on the registered business entities, Wimpie Potgieter, the head of deal making at FNB Home Loans, says.
The bank uses the financial statements of the business entities to determine solvency, liquidity and cash-flow generation or available cash flow.
Potgieter says that if the applicant passes the credit records stage and the financial vetting stage, the next question is whether the assessment falls under the National Credit Act (NCA).
An application will fall under the NCA when it is in the name of:
* A natural person or persons (individual, joint and multiple applications where all applicants are natural persons all count); or
* A trust with one or two trustees.
If the application is in the name of a juristic person – a trust with more than two trustees, a close corporation or a Pty (proprietary limited company) – it is considered outside of the ambit of the NCA.
“The NCA assessment will attract a much more detailed look at the available disposable income to service the new lending, and the income declared by the applicant becomes very relevant,” Potgieter says.
“In both instances, a healthy cash flow is extremely important. It is thus imperative to declare accurate values, as this will be vetted against bank statements [and] financials. Expenses will be vetted against credit records, etc.
“It cannot be stressed enough how important it is to maintain a solid credit record, to conduct your bank accounts well (such as remaining within agreed facilities and ensuring you provide for payments so that you do not have returned debit orders) and to maintain proper and up-to-date financials.”
Ross Linstrom, a Standard Bank spokesman, says the definition of “self-employed” is any individual who is not permanently employed with a fixed monthly salary and who has a percentage ownership in a business from which income is being derived to support the loan application. Standard Bank does not specify the ownership percentage, and Linstrom says the percentage is considered on a case-by-case basis.
“The definition of a self-employed individual is primarily based on the fact that the person relies on income generated from a business in which they own any percentage and/or all of the shareholding or member’s interest,” Linstrom says.
“The income generated in the case of a self-employed individual is generally not fixed and may fluctuate from month to month, hence the importance of having a manual credit assessment process for this type of applicant,” he says.
“In certain instances, we find an employed individual (with a permanent work contract and a fixed monthly salary) who also has a percentage ownership in a business. Where they rely on the income generated from this business to help them qualify for the loan sought, they will be considered on the basis of being self-employed.
“If no reliance is placed on the business and they qualify only on their employed income, they are considered on the basis of being employed.
“Our credit process encompasses the assessment of the latest two years' comparable financial statements (audited or certified, depending on the nature of the business entity). We also ask for the personal and business bank statements for the last three months to ensure there has been positive cash flow through the accounts and to justify repayment ability.”
This enables the bank to scrutinise how your banking affairs and those of the business have been conducted over the previous two years.
Standard Bank prefers self-employed applicants to have a business banking relationship with the bank so that it can accurately determine and measure the credit criteria necessary for a loan.
Linstrom adds that a person employed with a variable monthly income – such as a commission earner – is considered as being employed rather than self-employed. However, the credit risk requirements are a bit more cumbersome.
“We require a six-month view (in other words, the latest six months of payslips reflecting the commission, as well as six months of bank statements) of the income trend to determine the repayment ability of the applicant,” he says.
* Tess Rodrigues is the managing director of Property Factor, a specialist in property financing.
This article was first published in the third-quarter 2011 edition of Personal Finance magazine.