Tips for Getting a Mortgage When you Work for Yourself
If you are your own boss, getting a mortgage may be more challenging than it is for others. This is due to several reasons. First, self-employed individuals are subject to a much more rigorous document-gathering discovery phase than the rest of the population. They are also subject to much more stringent evidence requirements. It is not impossible to get a mortgage when you are working for yourself, but you may have to do more in-depth advanced planning or look outside of traditional financing opportunities to make things work.
In the United States, approximately 9 million people are self-employed. According to the Bureau of Labor Statistics (BLS), this accounts for about six percent of all nonagricultural workers. Even though those individuals might earn a decent living, they may have trouble qualifying for home loans. This is because borrowers have a general requirement to supply two years' worth of tax returns. However, this can be difficult for those who are self-employed, as those tax returns may not be an accurate representation of their take-home pay. The heart of the problem may actually start with the definition of "self-employment." The Internal Revenue Service (IRS) has its own criteria for defining self-employment, which generally makes it more difficult for people to get a loan without showing a high income to the federal government.
Because of stringent IRS standards, self-employed individuals face a number of hurdles when they need to get a mortgage. One obstacle is the liquidity test. This test compares the ratio of liquid and near-liquid assets to a person's current liabilities. This is also known as "Current Ratio" or "Working Capital Ratio." With a ratio of one or higher, people can look forward to a wide range of mortgage financing options. A ratio below one, however, can signal trouble. A ratio below one is seen as a red flag for many lenders, and many will not even consider mortgage seekers in that category. People in this category will also be excluded from the Federal National Mortgage Association (FNMA).
Another issue facing people who work on their own is the document gathering and discovery phase of mortgage lending. In the United States, people who are employed by others complete a standard W2 form every year. They only need to submit a few paystubs and tax returns as part of the discovery process. For those who are self-employed, however, the standard of evidence is much higher. People in this category start by submitting two years' worth of tax returns (personal and business) with complete records (no pages missing). They must also include a year-to-date Profit & Loss Statement, a current Balance Sheet, and an accountant's letter stating that the business has been in operation for at least two years, ideally in the same location, and that any money deposited in the company's bank accounts will not negatively affect the business. Self-employed individuals must also submit a copy of their business license. In addition to those standard requirements, underwriters can request a range of additional supporting evidence to supplement information provided on the other documents.
After collecting and submitting the required documents, self-employed individuals must then wait for lender review and analysis. Income analysis, which uses standard FNMA worksheets, is relatively simple and straightforward, as the numbers are simply transferred over from tax returns. The results, however, may open up another round of interrogation. Lenders will consider whether income has been stable over the years, whether it's been increasing, or the red flag – if it's been declining. If the latter is the case, why has the income been falling, and is there any evidence that it will change? Lenders may also question why an income was reported on a certain schedule one year, and then reported on a different schedule later on. They will also look at whether income reported on the Year-To-Date Profit & Loss sheet mirrors income that was reported on the previous year's tax return.
Before making a move, experts advise the self-employed crowd to plan in advance before borrowing for a home. The easiest way to do this is to write off fewer expenses in the two years prior to buying a home. People should also completely separate business and personal funds to avoid any confusion and possible holdups. If you are planning to get a new computer, for instance, it's in your interest to pay for it using a business card instead of a personal card, as some lenders will not count that debt against you personally because it belongs to your business.
Many lenders are okay with seeing income dips and spikes in the past two years, but they will balk at an income decline from one year to the next. Their rationale is that businesses can be volatile and unpredictable, and problems will arise if income is good one year, but only half as good the next. If you can, try to show a positive trend in your earnings over the years. However, if you have had an erratic income in the past few years, consider finding a co-signer on the mortgage with a higher and more stable income. You can also try to find a smaller loan that has less potential barriers for qualification. If your goal is an investment, then you can enter the field of mortgages by purchasing a condominium or a townhome. Among self-employed mortgage applicants, a declining income is one of the biggest issues preventing them from getting a loan. But even in this case, all is not lost. If a borrower's income declines by less than 20 percent, he or she may still find a lender willing to provide a loan. Some lenders will qualify applicants based on their income from the previous year. Applicants will likely have to submit a year-to-date profit and loss statement from their accountant too.
After proving income, applicants must also demonstrate that their business actually exists. Some lenders will accept applications with two years' worth of tax returns. Others require more substantial proof. If you need to show additional verification documents, you can submit a letter from your accountant, a business license, copies of all 1099 statements, and either proof of a website or client statements showing business transactions. To qualify for a mortgage, many self-employed people have to show that they've worked for themselves for at least two years. However, lenders sometimes make exceptions for people who are showing one year of self-employment on their tax returns as long as they also submit a W2 from a previous employer in the same field of work.
In addition to these options, people who are self-employed may be eligible for an alternative loan. This type of loan, called the "alternative income verification loan," opens doors for people who are self-employed and looking for a mortgage. You may have to find a niche lender for this type of loan, which resembles the "no-doc" and "stated income" home loans from the past. For lenders and borrowers, the process of qualification is much simpler. To start, the lender will request a year's worth of business bank statements and personal bank statements to generate a cash flow report. Then, the lender determines how much, if any, positive cash flow an individual has. The applicant must also provide the company with a profit-and-loss statement that matches his or her bank statements.
Despite the challenge in getting a mortgage, people who are self-employed can take several steps to improve their chances of approval. To start, keep in mind that some lenders understand the difficulties that self-employed individuals face, and they work with individuals to make a mortgage work. Some mortgage lenders let people add certain deductions back into their income like depreciation, depletion, or non-recurring payments. Finding a co-signer with a higher, more stable income is probably the best choice of securing a loan. Additionally, applicants can make a larger down payment if they are otherwise within reach of qualifying, and if the smaller loan reduces their debt-to-income ratio. Essentially, lenders issue loans based on qualifying income, and they are ultimately interested to see that borrowers will be able to repay their loan in the future. Having a good credit score can help self-employed people secure a loan, as can a lower debt-to-income ratio.
If you secure a mortgage as a self-employed worker, be prepared for future expenses. Lenders do not usually view self-employed participants as ideal borrowers, which can carry a hefty weight. Those who are self-employed usually end up paying higher interest rates than standard mortgage seekers. The self-employed group may also have a more difficult time shopping around for good rates and negotiating a lower interest rate.
As a self-employed worker, you may have to work harder than most to find lenders who are sympathetic to your situation and willing to work with you. However, with a bit of foresight and patience, you will be able to own and live in your home as an independent worker.