Millions of Americans have taken control of their careers as entrepreneurs and freelancers. Unfortunately, traditional mortgage rules can deliver an unpleasant dose of reality for aspiring homeowners who are self-employed when it comes time to buy a house.
If you are self-employed, either full time or part time, and have plans to purchase or refinance a home, there’s a lot you need to know to prepare for the potential challenges ahead.
Who is considered self-employed
For mortgage lenders, the standard definition of self-employment is having 25% or more ownership in a company that you derive income from. This includes all types of businesses, from sole proprietorships to LLCs and corporations.
Independent contractors and freelance workers may be considered self-employed as well, even though you might not have ownership in the company that pays you. If you receive 1099s at the end of the year, chances are you are self-employed.
Why it’s harder to get a mortgage when you’re self-employed
For traditional employees, lenders use the gross income reported on a W-2 tax form to evaluate you for a mortgage. For example, if you make a salary of $60,000 a year, your lender can use $5,000 per month to qualify you for a mortgage loan.
For self-employed workers, the calculations are much different. Lenders take into account your business expenses when determining your income.
Let’s look at that same $60,000, only this time if you earned it as your own employer. Before the lender can determine your qualifying income, they have to look at all the expenses you are deducting on your tax returns — including meals and entertainment, cellphones, internet service and mileage for your vehicle.
Assuming you have $20,000 per year in expenses for running your business, a mortgage lender will deduct the $20,000 from your $60,000 gross income, and the $40,000 that’s left is the income that can be used to qualify. That is your net income.
If you are self-employed, you would only have $3,333.33 per month of income that could be used to qualify for a new mortgage. That equals a much smaller house, or a larger down payment.
Documents you’ll need to provide if you are self-employed
Getting a mortgage as a self-employed borrower requires a bit more documentation and explanation as well. But is possible to get approved with diligence, persistence, and in many cases, the help of a good tax professional or CPA.
2 years of personal tax returns: Lenders will want all the pages and schedules of your personal federal tax returns.
2 years of business tax returns: If you own at least 25% of your business and your company is a partnership, LLC or corporation, you’ll need to provide two years of business returns with all pages of the federal schedules.
Year-to-date profit and loss and balance sheet: Besides looking at filed tax returns for the two most recent available tax years, lenders will want to get an idea of how things are going this year. By getting a profit and loss statement through the most current quarter or month, they can determine if things are getting better, getting worse or staying about the same. The profit and loss and balance sheet can be self-prepared, so you don’t necessarily need to pay a CPA or professional tax preparer for these documents.
Year-to-date business profit and loss statement and balance sheet: In addition to seeing how much income is coming to you this year, lenders will want to see how the business is doing. These don’t have to be audited financials — like with the personal returns, a self-prepared version generated from bookkeeping software is usually acceptable.
Audited financials for year-to-date income: If you need this year’s income to qualify, but the tax year isn’t over yet, you might need to provide audited financials. This can be a costly option, but if you’re having your best year ever and need the income to qualify for a higher house payment, this is an option.
Most current 2 months business and personal bank statements: Lenders will look at your bank statements to determine how the money is flowing into your personal accounts. If you are using funds from a business account to make a down payment on a house, you may need to provide business bank statements as well.
IRS 4506-T transcript request form: In the bad old days, many borrowers were coached to manufacture tax returns to qualify for mortgages if they were self-employed. To prevent a repeat of that, most lenders will require you sign an IRS 4506-T form to verify the information you provided on your tax returns is what you filed with the IRS.
What lenders are looking for if you’re self-employed
You can only prepare properly if you have an idea of what lenders look for when considering your application for a mortgage. Provide extra explanations upfront for any details about your business income that will keep them from guessing, and give them more evidence that you have the ability to repay the loan.
Large increases or decreases in your income
Lenders will usually average your net income over a two-year period to determine how much income to use to issue a loan. Any large increases or decreases can be causes for concern and result in the decline of your loan application.
The biggest red flag for most lenders is a 25% or more decline in self-employed income from the prior year. The explanation may be simple: You might have started up a new branch of your company and incurred a lot of expenses that won’t continue in future, or perhaps you changed the structure of your company from a sole proprietorship to a partnership.
The important thing is to provide an explanation, and preferably a letter from your CPA for any one-time tax losses you were taking. That way, the lender understands the company is in good financial shape and the losses were not due to hardship.
The same is true for large increases. Unless there is an explanation or documentation that the most recent year’s increase in income was due to something that will continue into the future, the lender will probably average the most recent year against a lower prior year to be conservative.
Keep in mind they are looking at the income and expenses for both you and your business. If your personal income has risen substantially in the past year, but there was also a significant drop in your company’s earnings, lenders will want to know what’s going on with the company.
How long you’ve been self-employed
If you’ve been self-employed more than five years, there are programs that will allow you to get approved with just your most recent year’s tax returns. If you have one rough year, but have been in business for decades, an underwriter may be willing to make an exception if you can document prior year’s earnings, and show that the current year’s earnings are back on track.
Business funds for down payments on a home
Combining your business funds with your personal money can get tricky in mortgage lending. Lenders will want you to verify that using those funds won’t affect business operations or cash flow, and they may want your tax professional to write something to that effect.
If you can come up with your down payment without accessing the company’s asset accounts, lenders may waive the requirement for the business tax returns.
Type of business you are in
If you work in a business or industry that has seen rough days lately, or one that appears to be in early growth stages, lenders may scrutinize more carefully the reasons for your drops or rises in income. They might require more documentation or reduce the amount of loan they are willing to qualify you for.
Different types of loans for self-employed borrowers
Conventional loans are generally the most sought-after to get the best rates and terms. Fannie Mae and Freddie Mac are the two of the largest purchasers of mortgage in the U.S. mortgage market and dictate most of the terms. Generally, they take into account the last two years of personal and business tax returns.
Freddie Mac makes an important distinction for business owners who are qualifying with a company that’s been in existence at least five years. The requirement for tax returns can be reduced to only one year’s worth of personal and business returns if you can provide a letter from your CPA or certified tax professional confirming your company has been in existence at least five years.
The FHA program requires the same two-year income history as Fannie Mae. However, since the credit score requirements are lower, self-employed borrowers may have more flexibility to get approved. Minimum credit scores can be as low as 580, versus the 620 required by Fannie Mae.
The requirement for business returns can be waived if your personal tax returns show your income has risen over the past two years, and none of the funds you’ll use at closing are coming from your business accounts.
Self-employed military veterans will be required to provide the standard two years of tax returns, plus a year-to-date income verification.
The VA uses a “residual income” analysis, which looks at how much the veteran has every month after his total expenses including the new mortgage, are deducted from his net income. Depending on the size of the veteran’s family and the size of the house, self-employed military veterans may get the most flexibility in qualifying for a VA loan.
The USDA loan program offers loans for lower-income borrowers in rural areas. You might be surprised, though, by what properties in your area qualify.The standard two-year tax return requirements apply to USDA loan and underwriting and credit requirements are similar to FHA.
Final considerations for the self-employed mortgage applicant
First impressions are everything, and that’s especially true if you are self-employed and applying for a mortgage. If you know that your business had big changes in income over the past year, you have two choices: You can roll the dice and hope the numbers come up in your favor; or you can be proactive and provide explanations from your CPA and documentation to support all those changes. Regardless, you’ll want to work with a loan officer who has some experience with self-employed borrowers.