Self-employment has a lot of perks. Trading the long commutes, cubicles, and endless meetings for a more flexible, location independent lifestyle can feel like a major upgrade. And who wouldn’t love swapping business casual for pajamas?
It’s been reported half to two-thirds of Millennials find the idea of entrepreneurship very attractive. And can we blame them? They’ve witnessed their parents’ job instability, decreasing company loyalty, and the lingering wounds of The Great Recession. Working for yourself seems like a no-brainer when considering these discouraging realities. But self-employment isn’t always so simple.
Despite the many benefits, self-employed workers often struggle to secure a mortgage due to strict regulations, more tax deductions, higher debt-to-income ratios, and lower credit scores.
Scrutiny From Fannie and Freddie
Qualifying for a mortgage is never easy, but the underwriting process is even more complicated for America’s 15 million self-employed workers. It becomes an even bigger headache when it involves government-backed mortgage giants Fannie Mae and Freddie Mac.
Fannie Mae requires lenders to analyze the stability of a borrower’s income, their type of the business and where it’s located, the demand for their products and services, the business’ overall financial health, and its projected revenue for the future. Also, lenders must review a two-year history of the borrower’s earnings.
Freddie Mac follows a similar process to verify a self-employed borrower’s income. This includes analyzing the borrower’s experience in their industry, identifying reasons for significant increases or decreases in income, and even proof the business exists from a third party.
The Consumer Financial Protection Bureau responded to the financial crisis by creating the ability-to-repay rule. Its purpose? To ensure borrowers can actually afford their loans. A qualified mortgage can only be approved if a borrower has met the ability-to-repay guidelines. This type of loan protects borrowers from predatory lending practices and lenders from potential lawsuits if the borrower has trouble repaying. Lenders like qualified mortgages because they can be resold to Fannie Mae and Freddie Mac, freeing up cash for additional loans.
How Tax Deductions Can Hurt
Being self-employed can be incredibly expensive and the massive tax burden only adds to the challenge. Fortunately, many workers can reduce their liabilities by lowering their taxable income. How is this accomplished? Tax deductions. Deductions can include a variety of business expenses including home office, transportation, equipment, education, and more. Although this may amount to significant annual savings, it may cause difficulties when applying for a mortgage.
Did you know lenders evaluate the income of salaried or hourly workers differently than self-employed? Traditional workers are evaluated on gross income, but self-employed borrowers have to report their net income on mortgage applications.
Self-employed workers typically claim as many deductions as possible and these deductions significantly lower the worker’s taxable income. This creates an incomplete picture of the borrower’s past and future earning ability. By claiming these tax deductions, the borrower may be unknowingly creating a roadblock on the path to a mortgage.
Debt-To-Income Ratio is Critical
A lower net income impacts the most important factor in being qualified for a mortgage – the borrower’s debt-to-income ratio. The self-employed worker’s debt-to-income ratio is calculated by averaging net income from their two most recent tax returns and the year-to-date income and expenses. A borrower’s debt-to-income ratio can be no higher than 43% to be approved for a qualified mortgage.
If you’re planning to buy a home within the next two years, you may want to consider reducing or eliminating tax deductions until after you’ve been approved for a mortgage. A certified public accountant can help you weigh the pros and cons. Also, they can help reduce net income by amending a tax return.
Some lenders have more experience underwriting mortgages for the self-employed. Finding a knowledgeable loan officer who’s able to analyze tax returns and the business’ financial statements can make a huge difference. Remember, a low debt-to-income ratio may help create wiggle room for other challenging areas of the underwriting process.
Self-Employed Workers Have Lower Credit Scores
Most of us understand the importance of a strong credit score, but many are confused about how it affects the mortgage underwriting process.
A recent Zillow study found that despite earning higher incomes, self-employed borrowers receive 40 percent fewer loan quotes from lenders. Why? Lower credit scores. The study cites self-employed borrowers are twice as likely to have a credit score below 680. This less than optimal credit score coupled with massive amounts of paperwork make self-employed borrowers less attractive to lenders.
A lower credit score can also make a mortgage more expensive. The best mortgage rates and terms are offered to borrowers with a FICO score of 740 or higher. So, what’s the best method of defense? Advanced preparation. Arm yourself with knowledge by reviewing your FICO credit score, disputing any errors you find, and then researching the lowest interest rates.
Think Creatively To Accomplish Your Goal
If you’re still struggling to be approved, you may need to think creatively to meet your goal.
How much home do you really need? Evaluating needs vs. wants is important and may lead to a property you’re more likely to qualify for. Avoid properties with mandatory homeowner association fees (HOA) because this expense gets lumped into the overall mortgage calculation.
How much have you saved for a down payment? Parting with the extra cash may make you cringe, but a larger sum reduces the size of the loan and may make it easier to qualify for.
If you’re still having trouble, there’s nothing wrong with finding a trusted partner to cosign the loan. Together, your combined income may close the qualifying debt-to-income ratio gap and earn approval on your must-have loan.
Securing a mortgage when you’re self-employed isn’t easy, but it’s possible. Preparing yourself for the challenges of Fannie and Freddie’s strict regulations, the disadvantages of tax deductions, higher debt-to-income ratios, and lower credit scores will give you the best possible chance of being approved for a mortgage and moving into your new home.