Most people who are self-employed think that getting a mortgage is out of reach for them, but it doesn’t necessarily mean that you will have to forego the idea of owning your own home. Many self-employed people earn a good living; but without a regular paycheck to depend on, most of them may have a hard time trying to prove their income.
What most lenders are primarily focused on when it comes to lending is the ability of the borrower to repay the mortgage. They will assess if your income is high enough to pay for the mortgage, whether your income is likely to continue, and whether you have a proven track record of repaying your debts.
For self-employed people, work history matters. Lenders will want to see that you have received a steady income for at least the last two years and that you have the necessary paperwork to prove it – especially if you are a 1099 worker. Assuming that you recently became self-employed, and have a W-2 form from the same field, some lenders will make an exception to the two-year rule.
Work history also comes into play when lenders are determining the approval amount. Lenders will generally take an average of your earnings over the past few years to determine the mortgage amount you will be approved for.
Before the 2007 credit crunch, self-employed borrowers could apply for a “self-certification” mortgage. With the loans, borrowers were not required to prove their income using bank statements or pay stubs; rather, they simply told lenders what they earned. Applications for mortgages were fast-tracked through, with no checks being made.
Self-certifications aimed at freelancers, contractors, business owners, and people with several sources of income, were sold more widely. Abuse of the system led to the self-certification mortgage being dubbed “liar loans,” as borrowers were exaggerating their income in order to secure a larger mortgage. This led to fast-track and self-certification mortgages being banned, making it much more difficult – but not impossible – to get a mortgage if self-employed.
When applying for a mortgage as a self-employed worker, you will need to provide documents including your business and personal tax returns for the past two years, a profit and loss statement or a 1099 form, business and personal bank statements, a list of your assets, a list of your debts, and a list highlighting all of your monthly payments. In this case, it is helpful that you hire an accountant to help you prepare the necessary documents so you do not overlook or forget anything.
According to Fannie Mae, lenders will consider the demand of your business, its location, its financial strength, and whether the business is capable of continuing to provide you with the required income to support a mortgage.
Determining your income
Determining precise income may pose an obstacle for self-employed workers. Self-employed people often have multiple streams of income that may fluctuate; documenting all this income requires more paperwork. Compare this to a traditional borrower, who receives a regular paycheck and has a W-2 tax form on which the employer reports the employee’s annual wages.
“A W-2 employee usually sees consistent wages from year to year,” says Scott Scribner, Realtor and board member of the National Association for the Self-Employed. “The self-employed borrower often experiences fluctuations in annual income, which can make it difficult for mortgage lenders to predict future income.”
Credit score matters
When trying to obtain a mortgage as a self-employed worker, your credit score will matter a lot. When applying, you will have to make sure that your score is in top shape. If you can wait and pay off a significant amount of debt before applying, you should do it. It is equally important that you check your credit report carefully to ensure that there are no mistakes.
One of the big indicators of whether you will be approved is a low debt-to-income ratio. This is the portion of your monthly earnings that go towards paying your debt. Lenders prefer that you have no consumer debt and large cash reserves.
Tax deductions are risky
As a business owner, you are familiar with business tax deductions and the impact they can have on your taxable income and your tax bill. Lenders will consider your after-deduction income when deciding whether to approve your mortgage application. Therefore, if you claim a lot of deductions when doing your taxes, it will actually lower your after-deduction income significantly, either preventing you from qualifying for a mortgage, or qualifying you for a mortgage that is too low. Keep this in mind when claiming deductions on your taxes.
The application process and gaining approval for a mortgage as a self-employed worker may seem like a daunting task. However, it is not as complicated as you may think. As long as you have the right documentation, a high credit score, a low debt-to-income ratio, and a healthy income and cash reserves, securing a mortgage as a self-employed worker is very possible.