📌 FHA Loan FAQ: Do I Need a Manual Downgrade for a Decline in Self-Employment Income?

Question:
My client has W-2 income and some side self-employment income that declined by more than 20% this year. We’re not using that income to qualify — do I still need to downgrade to a manual underwrite?

Answer:
No — as long as the self-employment income is not used to qualify the borrower, a manual downgrade is not required, even if that income declined by more than 20%.

✅ FHA Handbook 4000.1 Clarifies the Rule:

According to the FHA Single Family Housing Policy Handbook 4000.1, the requirement for a manual downgrade is tied specifically to “Effective Income” — which refers only to income being used for qualification.

“If the income from businesses shows a greater than 20 percent decline in Effective Income over the analysis period, the Mortgagee must downgrade and manually underwrite.”
— FHA Handbook 4000.1, Section II.A.4.c.x(B)(2), p. 229

So if you’re not using the self-employment income (like side business or hobby income) in the DTI or qualifying income, then a decline doesn’t trigger a manual downgrade.

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🧠 Pro Tip for Lenders:

• Be sure the file clearly documents that the self-employment income is not used to qualify.
• If the income is showing a loss, treat it appropriately (as a liability or adjustment).
• Stable W-2 income and strong reserves can carry the file — no need to downgrade just because of a side hustle fluctuation.