I always thought self-employment was really risky.
I worked as a mortgage underwriter at a bank for several years. I’d run loan applications through a submission process to Fannie Mae, a government-sponsored loan originator in the U.S. Without Fannie Mae's approval, the bank wouldn’t do the loan.
Fannie Mae’s underwriting system would weigh different factors about the applicants, with one of the primary factors being income. I’d get an automated decision about the application: approved or denied.
The results were clear: self-employment was considered riskier and the loans were harder to get approved. Back then, only a handful of the loan applicants were self-employed. That was two decades ago.
I have thought about this a lot since I entered the realm of self-employment. I’m lucky that I took out a mortgage years ago. I’m lucky that my spouse has a 9-5 job with an employer to offset the “risk” in a banker’s eyes.
But I think it’s going to become more of an issue as more people pursue a self-employment path. And most likely have no idea of the impact it may have on their future ability to work with a bank.
Most importantly, I think banks need to rethink their definition of risk.
Financial stumbling blocks for the self-employed
For the purposes of approving a loan in the U.S., self-employment is treated differently. Someone with an employer needs to supply only a few paystubs to verify income. But a self-employed person has to show two years of tax returns to prove their income was “stable.”
I remember one applicant in particular. He owned a bunch of rental properties and lived off the income they generated. On paper, it was hard to get his loan approved — because, as every self-employed person knows, you do everything you can to reduce your taxable income.
Back then, the types of self-employment were also different. A self-employed person might be an owner of a local restaurant. “Online creator” didn’t exist back then. Heck, back when I was processing loans, Facebook and YouTube didn’t exist either.
Today, there are about 11 million full-time creators in the U.S. According to a 2022 survey by McKinsey, 36% of respondents identified as independent workers. That’s an increase of 9% since a previous estimation in 2016.
That means that traditional loan underwriting may not work for a significant portion of the U.S. population. The automated decisioning needs to change, or banks will need to look at the loan more closely (yes, with a human reviewer) to determine the level of risk based on the sources of income and other factors.
I recently applied for a business line of credit (which I think is a smart move for any self-employed person, as it gives you access to money in case of emergency). Business loans are very different from home loans, but I was amused that the loan underwriter asked, “Do you have an online presence I can review?” Is this the future of loan approvals? Who knows.
But many people don’t think about their future creditworthiness when they decide to become self-employed. They think about how they’ll find clients and how they’ll collect payment. It isn’t until they apply for a loan (or even a credit card) that they realize that they’ll have a tougher time compared to the days of their 9-5 job.
Reassessing the definition of risk
About a year ago, Silicon Valley Bank collapsed. And while the reasons are complicated, SVB was unique because it was a magnet for tech startups. Part of the reason was that they’re different from other types of businesses. As banks assessed risk, startups didn’t fit into the mold of restaurants, hotels, car dealers, and other types of businesses banks were used to dealing with.
And self-employment is similarly different, especially with the rise of creators and other types of self-employment that exist now and didn’t exist even a decade ago.
I hope that banks will find ways to serve this segment of the population. I don’t want to see another SVB situation, where all creators have to flock to a single bank because other banks won’t approve their loans. The other scenario is that non-traditional lenders emerge, willing to provide loans to online creators. But these loans are typically at much higher interest rates and unfavorable terms. It’s better for everyone for banks to adapt.
I also vehemently argue that self-employment can be less risky than a 9-5 job. If someone loses a job, they lose 100% of their income. From a bank’s perspective, the ability to repay a loan is in jeopardy. For a self-employed person, losing a client or a gig may only be a portion of their income, not their whole income.
Of course, I’m mostly shouting into the void here. Some bank will need to decide that they benefit from re-thinking self-employment and changing their loan approval process. It might take larger changes to Fannie Mae and Freddie Mac underwriting standards.
But make no mistake, banks benefit from approving more loans because they earn interest. I’ve seen banks with niche loan offerings emerge before, and I’m hoping they will again. And I, as a self-employed freelance writer and online creator, am on high alert for that to happen.
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