Question: I am a self-employed consultant and I have two primary clients. My annual contracts with these customers agree to pay me over $150,000 per year in fees. I recently applied for a $400,000 mortgage to purchase a house and I locked into a great interest rate. A week later, after I sent the lender my tax returns, he calls me up and says that I don't qualify for the loan because my income is insufficient. He says that even though I make $150,000, my tax returns show nearly $100,000 in expenses. Mr. Savage, isn't the job of a good accountant to reduce my income on paper so I pay less tax? And shouldn't a loan officer know that self-employed people always show less income on their tax return than they really make? My credit is great and I'm putting down 20 percent, but the loan officer says I have to take a program with a higher rate that doesn't verify income. What's your take on this? Should I switch lenders?

Answer: You have asked a lot of questions so let me try to answer each one.

First, it is the job of an account to prepare your tax returns and deduct what legitimate expenses you have. The key word here is legitimate. Be very careful if your accountant is fudging expenses on your return. If you can't justify all your expenses to the IRS in the event of an audit, you're up the creek without a paddle.

Second, I don't believe all self-employed folks show less income on their return than they really make. As I said, all legitimate expenses should be accounted for, and what's left over is your taxable net income.

Third, most good loan officers understand that it's prudent business for a self-employed person use all the tax laws to his advantage and if there are legitimate expenses that reduce taxable income, he will save money on April 15th.

Herein lies your problem. Regardless of whether your expenses are legitimate, lenders won't count money earned as income for the purpose of the mortgage if you're reporting that same money to the IRS as a business expense.

Here's what I mean. You have gross fees of $150,000 per year and $100,000 in business expenses. This leaves you with $50,000 to live on. You are telling the IRS that you have a business that grosses $150,000 and in order to maintain your business, you must fork out $100,000 in various business related expenses. This could be travel, office space, photocopy machines, whatever. The issue here is that it costs you $100,000 to make the $150,000. Simple math. You've got $50,000 at the end of the journey.

Lenders merely want you to be consistent. You can't say to the IRS that it costs a hundred grand to run your business and then turn around and say to your loan officer that it really only costs twenty grand.

So I agree with your loan officer's assessment. You probably have to go with a "Stated Income" product. A Stated Income loan allows you to state your income on the application without verifying it.

Many lenders understand that self-employed borrowers have a difficult time documenting income. In order to make loans, they are prepared to rely more on credit history and down payment to determine creditworthiness. They take your word for it when it comes to income.

In most cases, you will have to pay a rate that's a bit higher - perhaps a quarter percent. But it's worth it to check around. There are some programs that allow Stated Income without jacking up the rate. Inquire about Adjustble Rate Mortgages (ARMs). A few weeks ago, I wrote about the London Interbank Offering Rate (LIBOR) mortgage. Still sitting pretty at 4.10 percent, this particular program allows Stated Income as long as your down payment is at least 20 percent.

A good independent mortgage broker should be able to recommend a few good products that allow Stated Income. Remember one thing, however. The income that you write down on the application must make sense in relation to what you do. If you are a self-employed manual laborer and you write your income down as $150,000, it probably won't fly in the underwriting department.

Published: April 11, 2002

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.