Most applicants are prepared to jump through a few hoops to qualify for a mortgage, but if you're one of the 15-million self-employed Americans, according to the 2015 U.S. Bureau of Labor Statistics, you may have a few more hoops to face than the average borrower.
One thing that self-employed borrowers all have in common is they will have a tougher time securing a mortgage than a traditional W-2 employee. In the wake of the 2008 housing crisis & new federal mortgage regulations as part of the Dodd-Frank mortgage reforms, mortgage lenders & investors have tightened the lending requirements needed in order to secure a home loan.
I've outlined a few of the common experiences that many self-employed borrowers face when applying for a mortgage. But don't worry if you are self-employed- there are special mortgage programs available, as well as steps you can take to make yourself a more attractive loan candidate.
A borrower's income is still probably the single most important factor for a home loan. For mortgage lenders to know what you earn, they will want to see at least the last two-years of a self-employed borrower's Schedule C from an IRS Form 1040. Schedule C is the tax form that represents the income or loss from a business. If income increases between year one and year two, lenders will take an average of the two years. However, if the second year's most recent income is lower, than the first year, lenders are required to use the lower number. See the chart illustration below, to see an example of how lenders use averaging income.
Lenders may also request a year-to-date profit and loss statement from an accountant when a borrower's income declined by less than 20 percent, in order to qualify them based on the previous year's income.
People who individually operate multiple companies will usually need to provide two years of tax returns for each company in which they own 25 percent or more.
Steps you may take to Improve Your Loan Approval Chances
Consider adding a Co-Borrower to the loan
Self-employed borrowers who apply with a co-applicant still need to follow the same process of proving income. Those self-employed borrowers who report a loss on their taxes may be better off applying only with a co-applicant's income.
For example, if one borrower earns $100,000 and the other has declared a business loss of ($10,000), their combined income is $90,000. Keep in mind that the co-borrower will need to be willing and able to assume full responsibility for the loan in the case you default.
What you may need to do: Discuss your income situation with your mortgage professional, they can help instruct you, should you need to add an additional borrower to the loan for qualification purposes.
Take Less in Business Tax Deductions
Self-employed individuals typically report their gross income minus expenses to generate a net income. For tax purposes, it may be beneficial to have net income as low as possible, but the net income is the number lenders use for income qualification for a home loan.
Since mortgage eligibility is based on net income, any business deductions you make at tax time, actually count against the borrower. Borrowers have to decide what is more important to them: qualifying for a larger mortgage or avoiding paying higher taxes.
The only exception to the business tax deduction rule, is depreciation on business-related purchases. Business depreciation is added back into the borrower's net income to help them qualify.
What you may need to do: Take less in business expenses in order to generate more income. Consider working with a Sierra Pacific Mortgage Professional and your tax professional now- even if you are planning on applying for a mortgage several years out.
If buying or refinancing a home is on your horizon, then consider not writing off every business expense. Although you may pay more in taxes, you will also show a higher net income for your home loan qualification.
If time is not on your side, as a last resort, you can amend your tax return to show that you have an increased net income." (The IRS has a three-year statute of limitations on amended returns.) Again, consult your mortgage and tax professional before proceeding.
Keep Accurate Records & Paper Trails
Documenting the source of funds for a down payment can add additional stress to your mortgage loan process. Especially if you use the same account for business and for personal use. Deposit amounts will vary by the individual's scenario, but any deposits of more than a few hundred dollars, if they are not clearly identified as to their source, will need a paper trail explaining the reason and source of the deposit. This could be a big headache for a borrower to explain every single deposit, if accounts are intermingled.
What you may need to do: Many self-employed borrowers use their business and personal bank accounts interchangeably. If you are planning to buy a home loan, it is recommended that self-employed borrowers keep separate business and personal accounts, so that the source of funds is easier to document and explain, if necessary.
Proving your Business Presence
In addition to proving income, borrowers must also prove that their business exists. For some lenders, two years of tax returns are sufficient. But other options for verifying a business may include: A statement from an accountant, a business license, a website, copies of 1099 income statements, profit and loss statements, and business balance sheets.
What you may want to do: Plan ahead, and be prepared to give your lender backup information proving your business presence.
Established Work History
Self-employed individuals must have been self-employed for two-years to qualify for a mortgage. Sometimes exceptions can be made for someone who can show one-year of self-employment on their taxes as well as W2s from a previous employer, as long as it was in the same field of work.
Sierra Pacific Mortgage does have a 1-yr tax history program for those who qualify. Call (855) SWM-LOAN for more information.
Steps to Make Yourself an Attractive Candidate to the Underwriter
Maximize your Credit Score
All borrowers need to have good credit for a home loan. But having a higher credit score can help offset potential risk factors, and give a lender greater confidence when considering you for a mortgage loan.
Plus, having a higher credit score will make a more attractive candidate to get the loan in the first place and help a borrower qualify for lower interest rate. Minimum scores of 620 may be needed to qualify for an FHA Loan, and a score of 740 or higher is offered the best mortgage rates for a Conventional Loan Products
Offer a Large Down Payment
From a lender point of view, the higher your equity is in the home, the less likely you are to walk away from it during a financial strain. Therefore, the lender will see you as less of a risk if you have a large down payment.
A 20-percent down payment is ideal for conventional loan products, but programs may be available with as little as 3-percent down. While, FHA loan products require a minimum of 3.5-percent down. Talk to your mortgage professional for what mortgage product may be best for your financial goals.
Have Significant Cash Reserves & Assets
In addition to a large down payment, having an emergency fund or other assets will show the lender that even if your business takes a nosedive, you'll still be able to keep making your monthly mortgage payments. Lenders need to know that self-employed borrowers, whose income often fluctuates more than regular W2 employees, can handle their finances and have sufficient savings.
Self-employed retirement assets such as Individual Retirement Accounts (IRA), Self Employed Pension plans (SEP IRA), or other asset accounts will help prove sufficient asset reserves, should a borrower face a period of financial strain.
Have a Low Debt-to-Income Ratio
The fewer monthly debt payments you have going into the mortgage process, the better it will appear to the lender that you can meet your mortgage obligations. If you pay down your credit cards and car loans, you may even qualify for a higher loan amount because you'll have a higher cash flow. Discuss your credit openly with your Sierra Pacific Mortgage Professional- together you can work through any hidden surprises early-on.
Lenders typically like to see an overall debt-to-income ratio of 42% or less, (the percentage of monthly gross income used to pay monthly debts) although borrowers with other compensating factors may qualify for a higher ratio. Bottom line, paying off some bills to reduce your debt-to-income ratio can be another compensating factor in your favor.
Important note: be sure you talk to your mortgage professional before deciding to close any credit accounts! Closing credit loans or other installment accounts may have the potential to negatively affect your credit score.
Have an Established Record of Self-Employment
Have at least two years of self-employment history. This shows that you know how to manage your workplace and income to the lender.
Be Willing to Provide Documentation
Be willing to fully document your income through previous years' tax returns, profit and loss statements, balance sheets and the like, will increase your chances of qualifying for a home loan.
Four Ways Self-Employed Borrowers Can Help Improve their Loan Chances
1). Self-employed borrowers need to understand that the most they can borrow is simply based on their qualified income. If there's little to no income shown on tax returns, then there's little qualifying income in which you may borrow against from a lender. The single most important factor is a borrower's ability to prove they can repay the loan from their income.
2). Borrowers who are close to qualifying, may want to consider a smaller loan size which lowers their debt-to-income ratio, or perhaps consider making a larger down payment.
3). Take steps to improve your credit score and lower your debt-to-income ratios.
4.) Keep great records of all your documents, including tax returns assets, and bank records.
If you'd like to know more about qualifying for a self-employed home loan or to get started, contact me below.
If you would like to know more about the types of Self-Employed Mortgage Loan Products available, I'm happy to help!
Branch Manager & Residential Mortgage Loan Originator
2580 St. Rose Pkwy., Suite #230
Henderson, NV 89074
Office: (702) 420-2250
Fax: (855) 689-6691
Some products and services may not be available in all states. Programs, rates, terms, and conditions are subject to change without notice. Subject to verification of borrower qualifications, property evaluations and credit approval. Terms and conditions apply. This is not a commitment to lend and not all borrowers will qualify. Sierra Pacific Mortgage Company, Inc. may not be the lender for all products offered. Some loans may be made by a lender with whom Sierra Pacific Mortgage has a business relationship. Sierra Pacific Mortgage Company, Inc. NMLS #1788. Nevada Commissioner of Mortgage License #3268. Additional license info available at: www.nmlsconsumeraccess.org. Equal Housing Lender.