If you’re self-employed and applying for a home loan, you may have heard that it is next to impossible to secure one. But fear not, the idea that self-employed people aren’t eligible for home loans is a common misconception.
The U.S. Bureau of Labor Statistics estimates that roughly 14 million people in the United States are self-employed. These people, like you, are hardworking individuals who need to buy homes and cars and secure lines of credit. The truth is, you’re as apt to get a mortgage as a traditional W2 employee. The second truth is, since you can’t produce the same documentation as “traditional employees,” you may have to provide a little more documentation to secure the same loan.
Similarities Between Loans for Self-Employed People and Traditional Employees
In many ways, getting a home loan for a self-employed professional will be a similar experience to a traditional employee. For starters, you’ll have access to common loan programs, such as conventional loans and FHA loans and in traditional terms such as 15-year or 30-year mortgages.
Once it comes time for underwriting, your lender is going to use the same general guidelines and procedure to determine whether or not you qualify. Underwriting relies on three key factors – the three Cs of borrowing – to make this determination:
- Capacity to Repay – To calculate your capacity to repay, lenders will look at your debt-to-income (DTI) ratio. This means they will see how much money is coming in each month and how much of it goes to outstanding debt, such as car payments and student loans. Since you do not have traditional W2 stubs, lenders will look at your past two years of income reported on your tax returns and will average that out over 24 months or possibly as few as 12 months of income history on your tax returns to arrive at your monthly income for qualifying purposes. Your lender will also look at checking, savings, or investment accounts to verify funds needed for down payment and closing costs, and it’s always prudent to have a little extra in reserve after closing to help you make payments in case of an unforeseen emergency (should your business go belly up).
- Credit History – Mortgage lenders will take a close look at your credit score and credit history to evaluate how you handle your debts. If you have a good history of managing credit and paying back loans, you are more likely to be approved.
- Collateral – The home you are purchasing is considered collateral, and a lender will want to know that the value of the property you are pledging as collateral is worth what you’ve agreed to pay for the home. To ensure you’re making a sound investment the lender will order and to verify the value of the home matches or exceeds what you’ve agreed to pay.
The Difference Between Traditional and Self-Employed Home Loans
The main difference between your experience applying for a mortgage and that of a traditional salaried employee will all boil down to how your income is analyzed.
As previously mentioned, with a typical mortgage the borrower would offer up their last two months of pay stubs and a year or two of W2’s. With these items, the lender will be able to see gross income before any deductions are taken out.
As a self-employed professional, you may not receive traditional, consistent pay stubs. Instead, you will have to hand over the last two years’ individual tax returns, and if you file separate corporate returns for your business, those will be required as well. In order to calculate your DTI ratio, they will look at your businesses’ bottom line and then add back in certain line items that represent “paper losses” on your tax returns.
Now, if you’re like most self-employed people, you take all of the business expenses and deductions that are allowed to offset operational costs. This means you might take off mileage, part of your utility bills (if you work from home) and some of your office supplies. These deductions leave you with a lower taxable income than what you’d have being a salaried employee and that’s the good news.
Having a lower taxable income means you pay less in taxes, and while an underwriter will deduct some expenses as a normal part of doing business from your gross business profit, there are several loses that the underwriter will ADD BACK to the bottom line. These add backs are essentially those line items on a tax return that do not represent an actual loss to the business, but do reduce your taxable income. Depreciation, Depletion, Casualty loss and Amortization are all line items on your tax return that the underwriter may add back to your bottom line. Other things like business use of the home, your own personal salary from the corporation, contributions to retirement accounts or dividends paid to you from the company are also items that an underwriter will evaluate to determine the true earnings of a business.
Additionally, if your business pays any liabilities that you may have incurred in order to run your company such as auto payments or company credit cards that appear as personal liabilities on your credit report, and you can verify a history of the company doing this without it having a negative bearing on the overall profitability of the company, and underwriter may elect to add back those expenses to the bottom line.
In short, the lending industry understands that the bottom line figure on your personal tax returns may not be entirely accurate when determining if your business generates sufficient income for you to repay the loan. That job should fall on the shoulders of your loan officer and their underwriter to thoroughly evaluate the tax returns to accurately determine your business fiscal health.
Your Job is to Make Yourself as Attractive as Possible
There was a time when a self-employed person could simply state their income, without offering much in the way of documentation (AKA proof of stated income) to obtain a mortgage. But those days are long behind us. While lenders will and do qualify self-employed individuals for home loans, you will definitely want to make your finances as attractive as possible.
Here are some ways to do that:
Get Your Finances and Documentation in Order
As we previously mentioned, be prepared to jump through many hoops. By that we mean, be prepared to hand over more documentation than you might think the lender really needs. You will save yourself time and frustration if you get your finances and documentation in order before you start shopping for mortgages. Getting organized up front will also help you know how much house you can afford.
Seek the Advice of a CPA
Does your business retain the services of a tax professional or CPA? If so, get them on board and let them know you are applying for a Mortgage. Getting the advice from a CPA will help you understand how home ownership will affect your personal tax liability AND how owning.
Just breathe, do your best to prepare your documentation and answer any questions the lender may have for you. Above all, understand that you are not being singled out or punished for, essentially, your entrepreneurial spirit. Lenders must do their due diligence when it comes to self-employed borrowers, so understand that the additional documentation requirements you may be subject to are being asked for because the lender really does want to see you get your mortgage! While YOUR job is running your business, THEIR job is to lend money. And if they don’t do THEIR job, they will likely be out of one!
America was built on the backs of small business owners and its current economic health depends on the self-employed workforce. And if you follow some of the guidelines we mentioned, you will have a much better chance of having a lender see you in a positive light.
If you’re looking to buy a home, get in touch with us today. We’ll work hard to make sure you secure the financing you need to make your American dream a reality.