Lending Criteria

Most lenders have their own methodology for assessing the income of a self employed individual or company applicant.  Financial statements & tax returns are, to a certain extent, open to interpretation.

How do Lenders calculate your income ?

As a general rule there are three main ways they can calculate your assessable income:
  • Averaging two years income: This is the popular method used by most lenders. Lenders that use this method also look for the percentage change of net profit over the two years. If your net income increases by more than 20% then they will commonly use the previous years income plus 20%, instead of the average. Unfortunately it isn’t the most accurate method if you have had a slower year or if you have only recently started your business.
  • Using your most recent years income: We believe this is the most accurate method of assessing a self employed person’s income. Only a couple of lenders use this method.
  • Using the lowest income from your two most recent years: This method is used by most lenders when the most recent years income is lower than the previous years income. They assume the downward trend will continue and so use the lowest figure in their assessment of your loan.
The figure that lenders use in the above calculation in assessing income is your personal taxable income which is commonly comprised of wages paid to yourself plus net profit (in the case of a company). However there are some final tweaks that lenders use to calculate this income. These tweaks are known as 'add backs'.

What is an “add back” ?

Your taxable income alone isn’t the same as your actual income that you could use to pay your existing commitments, plus the proposed repayments for your new mortgage. Lenders consider an add back as any expenses that you have incurred that have reduced your taxable income, however not all expenses are of a cash nature or necessarily will they be an ongoing commitment in future trading periods.


Some examples of add backs are:
  • Depreciation: Depreciation is a tax deduction however is not a day to day cash expense. For this reason some lenders add it back to your taxable income but amount of allowance varies depending on nature of asset being depreciated. Assets with a high turnover may have a reduced amount of depreciation permitted as an add back by the lender.
  • Additional superannuation: If you have made lump sum or regular voluntary super contributions in excess of your minimum statute requirements then these extra amounts can be added back in most cases.
  • Net Profit Before Tax (NPBT): If you have profits that you have retained in your company then these can be taken into account as well, but only for the period on which the credit assessment is based. If you don’t own the entire company then lenders will assess your share of those retained profits.
  • One off expenses: If you had an extraordinary expense then the lender will often add this back. An Accountant's letter confirming this will be required.
  • Interest & lease expenses: If you have a business loan or investment loan, then it is likely that you have tax deductions for the interest that you have paid. Lenders will add this back as they will assess all commitments that you have separately in their serviceability calculator.
  • Rental property expenses: Depreciation on your properties, management fees, repairs and other rental property deductions such as negative gearing are all added back. Rental income is also deducted from your income as lenders assess this separately to your main income.
  • Company car: If you have a car that is used by your business and yourself then it is likely that you have deducted many of the expenses associated with this car for tax. Lenders do not add this back, however they often will add in an extra $3,000 to $6,000 in income to compensate for this if it is the sole vehilce within the family unit. Where a private vehcile is maintained within the family then no allowance will be considered.
  • Trust distributions: If you have your business in a discretionary trust and have chosen to distribute income to some of your family members then in most cases this can be added back. Note that many lenders do not accept this add back, or will only do so if you provide a letter from your accountant to confirm that the beneficiaries are not financially dependent on this income.
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 How recent are your tax returns ?

By 31 st December each year, most lenders begin to ask for tax returns for the most recently completed financial year. Up until that point you can generally provide the tax returns from the year before. So for example if you applied for a loan in November 2010, most lenders would require your tax returns for 2008 & 2009, however if you applied in January 2011, Lenders would require 2009 & 2010 in order that they are reviewing information that is not older than 18 months.

In addition to your individual and company tax returns, Lenders will require the supporting ATO Assessment Notices and Tax Portal (for company) to confirm that the returns they are assessing are one and the same that have been lodged to the Tax Department.

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Why might a Lender need a letter from your Accountant?

When assessing a loan application the lender needs to be certain that they are assessing your income and other aspects of your loan application in the correct way. A letter from your Accountant will help clarify these issues and can often allow Lenders to expand their guidelines to consider home loans that they would otherwise decline.


Accountant letter template

Your Accountant can use this sample letter as a template if they wish. All they need to do is copy it onto their letterhead, complete the relevant details, sign and fax/email to Puzzle Finance as part of your supporting documentation requirements. Puzzle Finance will provide guidance as to when a letter may be required to support your application and we can interact with your Accountant upon your consent if you prefer.

This sample letter can be used when the bank requires a letter confirming that a business is trading at a profit as the bank has not seen financial statements or tax returns for the business, possibly as there are other non-related Directors associated with the company but who are not borrowers on your application and do not wish for the company financials to be released to a 3 rd party such as a Lender or Broker

1/1/2011

To Whom It May Concern:

Re: John Smith & Smith Printing Pty Ltd

We confirm the following details regarding John Smith and his company Smith Printing Pty Ltd:
  • We act as the accountant for both John & Smith Printing Pty Ltd.
  • We confirm that to the best of our knowledge Smith Printing Pty Ltd is trading at a profit, is solvent, and can meet all of it's committments.
This information is true to the best of our knowledge and has been confirmed from independent enquiries with our customer and our own records.

Should you require any additional information please do not hesitate to contact our office on 03 1234 5678

Regards,

(SIGN)

Mr A C Countant
ACC Accounting Pty Ltd

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Other types of accountant letters

There are many different reasons why a bank may request an accountant’s letter, and so there are many different templates that you may need to use. Below we have included a sample of  text that may be inlcuded for the most common accountant’s letters.

Some common clarifications that lenders may ask :
  • Business not trading: We confirm that to the best of our knowledge Smith Printing Pty Ltd is no longer trading and has no liabilities of significance.
  • One off expenses: We confirm that Smith Printing Pty Ltd had a bad debt to their largest client in the 2009/2010 financial year which they were forced to write off. This is a one off event and is unlikely to occur again. It would be appropriate to add back this expense when calculating the customer’s ability to service a new loan.
  • Change in income between financial years: The profit generated by Smith Printing Pty Ltd significantly increased between the 2008/2009 and 2009/2010 financial periods. This is because John Smith was not working for over 6 months of the year due to a personal issue that required his attention. For this reason it would be appropriate to use the figures from the 2009/2010 financial year when assessing John’s ability to service a new loan or interim figures for the past trading quarter.
  • Change in income due to start up expenses: The profit generated by Smith Printing Pty Ltd has significantly increased between the 2008/2009 and 2009/2010 financial years. This is because 2008/2009 was the first year of the businesses operation and so there were one off start up expenses, initial advertising costs and a smaller existing customer base. For this reason it would be appropriate to use the 2009/2010 financial years income to assess John’s ability to service a new loan. Based on recently lodged BAS and independent inquiries with the director it would appear that this level of income is likely to continue or increase.
  • New business in the same industry as a previous job: We confirm that John Smith was previously employed as an IT consultant for 10 years before starting his own business in the same industry. Although John’s business has only been trading for one year it has already generated a substantial income and has a loyal customer base. Based on enquiries with the director and recently lodged BAS it would be reasonable to expect the income from John’s business in the next financial year to be equal to or better than that in the most recent 2009/2010 financial year.
  • Contractor with no major expenses: We confirm that John Smith is operating as a sole trader that contracts to an IT business. He is paid an hourly contract rate and has no major expenses such as staff, tools or rent that other types of businesses may incur. For this reason it would be reasonable to assess his income in a similar method to that of someone who is employed on a PAYG basis.
  • Change in ABN / Business structure: We confirm that Smith Printing Pty Ltd is the same business that was previously using John Smith’s sole trader ABN. Although this is a new entity, the business is essentially the same. John has been self-employed in this business for over 6 years. For this reason it would be reasonable to assess these two entities as the same business when assessing John Smith’s ability to service a new loan.
  • Family employees: We confirm that Anna Smith is employed by Smith Printing Pty Ltd which is owned by her father John Smith. She has been working for Smith Printing Pty Ltd for only four months and as such there has been no group certificate issued. We confirm that her income is $40,000 p.a. as shown on her payslips.
  • Loan purpose confirmation: We confirm that to the best of our knowledge John Smith is using the proposed loan from ABC Bank to invest in shares.
  • Discrestionary trust distributions: We confirm that John Smith is the sole director & shareholder of the trustee company and also the appointer for his discretionary trust. He has full control of the current and future distribution of income from the trust. He has chosen to distribute income from the trust to his mother and his sister to reduce his taxable income.
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Lender requirements for Accountant letters

Most lenders have standard format and requirements for letters from Accountants, and will often ask for a letter to be amended if it does not meet their requirements.

Your accountant letter should be:
  • On your Accountant’s company letterhead, including contact numbers, the firm’s ABN and any industry memberships/CPA qualifications
  • Dated
  • Signed
  • Contain the name of person who signed the letter
  • Contain the name of person who the letter is about, as well as their company (if applicable).
  • Should confirm that the firm acts as the Accountant for the person who the letter is about.
  • Most accountants will require some kind of disclaimer to be in the letter to protect them from legal action in the event that the letter is inaccurate. Your accountant can generally write whatever kind of disclaimer they like.
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