The Problem with Two-Year Income Averaging for Growing Businesses
For most homebuyers, qualifying for a mortgage is straightforward. Lenders look at W-2s, pay stubs, and tax returns to verify a stable income. But for a self-employed Texan whose business is hitting its stride, this standard process can feel like a punishment for success. The core issue is the lender's requirement to average your last two years of taxable income as reported on your federal tax returns.
This system is designed for stability, but it completely misses the reality of a growing business. A business owner's goal is often to minimize their taxable income through legitimate deductions and write-offs. While this is a smart tax strategy, it works directly against you during a mortgage application.
Consider this common Texas scenario:
- Year 1: You launched your business. After expenses and write-offs, your Schedule C showed a net income of $40,000.
- Year 2: Your business exploded. You hired help, expanded your services, and grossed significantly more. Your net income on your tax return was $140,000.
A traditional lender will add these two figures ($40,000 + $140,000 = $180,000) and divide by 24 months. Your qualifying monthly income would be just $7,500. However, your business might actually be bringing in $25,000 per month in gross revenue right now. The two-year average penalizes your slow start and doesn't reflect your current, much higher earning potential. This outdated model can leave you qualified for a home far below what your actual cash flow can support.
Using a 12-Month Bank Statement Loan in Texas
Fortunately, there's a powerful alternative designed specifically for this situation: the 12-month bank statement loan. This non-qualified mortgage (Non-QM) product allows lenders to verify your income using your business's real cash flow instead of its tax-minimized net income.
Here’s how it works in practice for a Texas business owner:
- Documentation: Instead of tax returns, you provide the lender with 12 consecutive months of your business bank statements. Personal statements can sometimes be used, but a dedicated business account is strongly preferred.
- Income Calculation: The lender analyzes your deposits. They are looking for consistent, business-related revenue. They will typically ignore large, unusual deposits (unless they can be sourced) and transfers from personal accounts.
- The Expense Factor: The lender applies an 'expense factor' to your total qualified deposits to estimate your net income. This factor is a standardized percentage meant to account for business operating costs. It often ranges from 30% to 50%, depending on your industry and the lender's guidelines. For a service-based business with low overhead, the factor might be lower. For a business that sells physical goods, it might be higher. (The data, information, or policy mentioned here may vary over time.)
A Real-World Example
Let’s say your Texas-based consulting firm has shown the following over the last 12 months:
- Total Business Deposits: $300,000
- Average Monthly Deposits: $25,000
- Lender's Expense Factor: 40% (meaning they assume 60% is your income)
The calculation would be: $25,000 (average monthly deposits) x 60% (income portion) = $15,000. This becomes your qualifying monthly income. This figure is double the $7,500 you would have qualified for using the two-year tax return average, unlocking a significantly higher home budget that aligns with your true financial situation.
Qualifying with a Profit & Loss (P&L) Statement
Another excellent option for Texas entrepreneurs is a loan based on a Profit & Loss (P&L) statement. This can be even more advantageous than a bank statement loan if your business has very low, verifiable expenses. While a bank statement loan uses a default expense factor, a P&L-only loan relies on an official statement, typically prepared and signed by a Certified Public Accountant (CPA) or licensed tax preparer.
This approach works best when your actual business expense ratio is lower than the lender's standard expense factor. For instance, if the lender's default factor is 50%, but your CPA can certify that your true business expenses are only 20% of your gross revenue, a P&L program would allow you to qualify with a much higher income.
To qualify using this method, you will generally need:
- A P&L statement for the most recent 12 or 24 months, plus a year-to-date P&L.
- A letter from your CPA verifying the accuracy of the P&L and confirming you have been in business for at least two years.
- Two to three months of business bank statements to show cash reserves and corroborate the revenue figures on the P&L. (The data, information, or policy mentioned here may vary over time.)
This option demonstrates financial sophistication and is ideal for businesses like solo consultants, freelance writers, or digital service providers with minimal overhead.
Lender Scrutiny: What Deposits and Expenses Matter?
When you use bank statements or a P&L, lenders shift their focus from tax documents to your day-to-day cash management. They are underwriting the health and consistency of your business operations.
Analyzing Your Deposits
- Consistency is Key: Lenders want to see a predictable pattern of deposits. Wildly fluctuating income can be a red flag unless it’s tied to a legitimately seasonal business (e.g., a landscaping company in Texas).
- Business-Related Revenue: Deposits should clearly come from your business activities. Funds from Venmo, Zelle, or PayPal are acceptable if they are linked to a business account and you can document they are for services rendered or products sold.
- Large, One-Off Deposits: If you had a single, unusually large deposit, be prepared to explain it. Was it from a major project, a client prepayment, or an asset sale? You will need to source it with an invoice or contract. Personal loans from family or cash infusions are not considered income.
Reviewing Your Expenses and Account Health
- Avoid Overdrafts (NSFs): Non-sufficient funds (NSF) fees or overdrafts are one of the biggest red flags. More than one or two in a 12-month period suggests poor cash management and can jeopardize your approval. Clean up your account habits for at least six months before applying.
- Commingling Funds: Lenders strongly prefer you use a dedicated business bank account. Constantly transferring money back and forth from personal accounts makes it difficult to distinguish business revenue from personal funds and complicates the underwriter's analysis.
- Recurring Debits: Underwriters will look at recurring payments leaving your account to ensure they are not undisclosed debts, such as an unlisted auto loan or personal loan payment.
Explaining Dips and Slow Months on Your Application
No business has perfect, linear growth. An occasional slow month or a dip in revenue will not automatically kill your approval, but you must be proactive in explaining it. The key is to provide a logical, documented reason that shows it was an exception, not the beginning of a downward trend.
Effective explanations include:
- Seasonality: 'My roofing business in the Dallas-Fort Worth area is always slower in January and February due to weather. Our peak season runs from April through October, as shown in the statements.'
- One-Time Capital Expense: 'The dip in June was caused by a $15,000 purchase of new equipment, which was a one-time investment to increase our production capacity. You can see revenue increased in the following months as a result.'
- Personal Event: 'I took a three-week unpaid family leave in August, which is why deposits for that month are lower. Business operations returned to normal in September.'
A brief, well-written letter of explanation (LOX) accompanying your application can address these issues before the underwriter even has to ask.
Are Interest Rates Higher for Alternative Income Loans?
It is important to be realistic: yes, interest rates for bank statement and P&L loans are typically higher than those for conventional or FHA loans. Lenders view loans with alternative income documentation as having a slightly higher risk profile, and the rate reflects that.
However, the increase is not punitive. You might see a rate that is 0.5% to 1.5% higher than the best-advertised conventional rates. Think of it as a trade-off. You are paying a modest premium for the lender's flexibility to recognize your actual income and approve you for a loan you otherwise couldn't get. For many Texas entrepreneurs, this slightly higher rate is a small price to pay to secure the right home for their family now, rather than waiting another two years for their tax returns to catch up to their success. (The data, information, or policy mentioned here may vary over time.)
Preparing Your Business Accounts for a Smooth Application
To ensure the fastest, most successful application process, start preparing your financials several months in advance.
- Use a Dedicated Business Account: If you are still running your business out of a personal checking account, stop. Open a business account immediately and run all revenue and expenses through it.
- Stop Commingling: Make clean owner's draws or salary payments to your personal account instead of using the business debit card for groceries and personal bills.
- Maintain a Healthy Balance: Avoid letting your account balance drop to zero. Lenders like to see a consistent cash cushion, as it shows financial stability.
- Keep Meticulous Records: Use accounting software like QuickBooks or hire a bookkeeper. Having clean, organized records makes it easy to produce a P&L or answer an underwriter's questions.
- Get Ahead of NSFs: Scrutinize your statements. If you have any overdrafts, ensure there are none in the 6-12 months leading up to your application.
If your recent business success isn't reflected on your tax returns, you still have powerful mortgage options in Texas. Discuss your specific scenario with a mortgage strategist who specializes in self-employed loans to see if a bank statement or P&L program fits your goals.
If your recent business success isn't reflected on your tax returns, you still have powerful mortgage options in Texas. A bank statement or P&L program could be the perfect fit for your goals. To see what you qualify for based on your real income, take the next step and apply now.
Author Bio
David Ghazaryan is the expert mortgage strategist and founder behind iQRATE Mortgages. With a mission to fund home loans that traditional banks won't touch, David specializes in helping clients with unique financial situations, including those recovering from foreclosure or bankruptcy. He expertly crafts smart, strategic, and stress-free mortgages by leveraging a vast network of over 100 lenders to secure competitive rates for investors and homebuyers alike. Praised for exceptional customer service, David has helped hundreds of families with a 97% satisfaction rate, guiding them to the mortgage they deserve.
