Being your own boss seems like the ultimate freedom, but there are definitely downsides to being self-employed and one of them raises its ugly head when you're preparing to be a first-time homebuyer. You'll have to overcome a variety of challenges to get a mortgage as a self-employed person, and the lender may put you at a higher interest rate. The process is easier to understand if you know what you are getting into before you begin, and there are a few things you can do before you apply that will increase your chances of success.
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Proving Income When Self-Employed
More people than ever are considered self-employed. This includes you if you own your own business, but it's not limited to store owners or professionals hanging out a shingle. You are also considered self-employed for tax purposes if you are classified as an independent contractor, a freelancer or a gig worker. Any self-employed person is likely to face more challenges in getting a mortgage than someone with a regular paycheck and a W-2. That's because it is harder for the lender to feel comfortable with your reported income.
To compensate for this, lenders impose stricter rules for self-employed borrowers than for those who are bringing home a regular paycheck. The key to being able to get the mortgage with minimal problems and delays is to know what the bank wants. If you walk in the door with the documentation you need, you are much closer to getting a loan.
Proving Stable Income While Self-Employed
There's no secret about what lenders are looking for when it comes to borrowers. They want to see:
- A high credit score reflecting a good credit history of paying monthly bills on time.
- Adequate cash or liquid assets to meet the down payment, escrow fees and other closing costs.
- A history of stable employment with sufficient verifiable income to qualify you for the loan.
It's the last factor that trips up most freelancers. The need for stable employment and verifiable income raises several challenges for some self-employed people. First, it should be noted that anyone who has recently switched to a gig-economy job may find it difficult to get a loan. Lenders don't like it if you've only been working for yourself for a short time (as it doesn't show a stable pattern) or make less money than the average borrower.
Even for people with a steady paycheck, lenders prefer borrowers who have worked at least two years in the same field. Though not a hard-and-fast rule, the two years of consistent work experience applies with even more force to those who are self-employed. You may be able to skate by if your new freelance work is in the same arena as your prior work, like a writer who works freelance for one business website and then starts writing for another business website. However, if you work as a freelance cook for a year and then start driving for a ride share service, the bank may not think your work history is sufficiently steady enough to give you a loan.
Another issue that arises for the self-employed is income level. The income of freelancers varies from year to year more than that of employees. In addition, self-employed people usually take full advantage of the business expense tax deductions available for them on federal returns. Anyone who maxes out their business deductions will definitely lower their net income, and this is great for income tax purposes. However, the resulting net income may drop to such a low point that they may not qualify for a mortgage.
Documenting Self-Employment Income
Lenders protect themselves by requiring additional income documentation for self-employed persons. The rules regarding what documentation is required can vary widely among lenders, so it's always a good idea to check with a specific lender before preparing an application.
Mortgage loan applicants who work as salaried employees prove their income by providing W-2 forms, the forms companies use to report their workers' income to the IRS. Since these forms are prepared by a third party — the employer — and are sent to the government, they are presumed to be accurate.
Self-employed borrowers do not receive W-2 forms, so they cannot use them as proof of income. To prove income, self-employed borrowers will need to show two or more years of 1040 tax returns, including all schedules as well as business tax returns (as applicable), balance sheets, a list of existing debts and assets and similar documents. You may also need to show a year-to-date profit and loss statement and your business license.
The lender will expect to see the self-employed person's income going up year over year, not going down. If the most recent year's tax return shows lower income than the return for the year before, the lender will not average the net income from the two returns for loan purposes but will simply use the most recent one. In fact, if the returns show significant decreases in income in the recent past, a borrower might be disqualified on the theory that the person's business is declining.
Secure a Mortgage with a High Credit Score
A self-employed person will need to take every possible step to present as a good candidate for a loan. This includes changing what you can, like your credit score. Credit scores are calculated with a formula that includes factors like a person's payment history and general level of debt as well as the number of credit accounts the individual has and the balances for those accounts.
Every potential borrower, whether an employee or a self-employed person, will need a good credit score to qualify for a loan. For a low-interest loan, you'll need an excellent score. As you start to get serious about buying a home, one of the first things you need to do is check your credit score. You can do this at any of the three main credit bureaus: Equifax, Experian and TransUnion. You can also get a free credit report once a year from each of the three bureaus.
Credit scores run from 300 to 850, and generally, the higher the score, the better luck an individual will have when borrowing money for a home loan. Debtors with a score of 720 to 850 are considered responsible enough for the best loans. A score of 800 to 850 is considered excellent and might help overcome barriers to obtaining a loan. As a self-employed person hoping to be a homeowner, you can increase your chances of getting a home loan by increasing your credit score. You can do that by making credit card and other recurring payments on time, not overdrawing your bank account, reducing debt levels and keeping unused credit accounts at a zero balance.
Have a Sizable Down Payment
Very few people buying real estate have the entire purchase price in cash. However, most buyers have some cash that they use as a down payment to pay off some of the purchase price, financing the rest with mortgage loans. Ideally, most lenders want to see a down payment of at least 20 percent of the purchase price — $20,000 for every $100,000 of the price — although some lenders, like the Federal Housing Administration, will loan money with a smaller down payment as little as 3.5 percent.
Self-employed homebuyers can help themselves get a mortgage by saving for a solid down payment. They will likely need at least a 20 percent down payment to qualify for a real estate loan, but given the strikes against a self-employed borrower, it's better to aim for 25 or even 30 percent down. The more liquid assets you have, the better chance you have of getting a mortgage. The lender will expect some extra cash flow to pay for closing costs and home maintenance expenses as well.
Understanding Debt-to-Income Issues
Debt-to-income (DTI) ratio is a major factor in every mortgage lender's decision-making process when it comes to home loans. What exactly is DTI? It is a ratio comparing a borrower's total monthly debt payments (credit cards, car loans, student loans, etc.) to their monthly income. For example, if a person's income is $4,000 a month and their total monthly debts are $2,000, then their debt-to-income ratio is 2,000/4,000, or 50 percent.
Banks want the DTI ratio — including the new mortgage payments for the loan the borrower is seeking — to be no more than 43 percent of monthly income. That means if you make $4,000 a month, you should not be paying more than $1,720 a month, including the new mortgage. Add up all of your monthly debts and then subtract that number from $1,720 to find out how much of a mortgage you can afford.
Having a DTI ratio of 43 percent or less isn't always easy if you have a number of outstanding debts. It's even harder for a self-employed person. While banks allow employees to use gross income (income before deductions) in their DTI ratio, self-employed borrowers must use whatever income remains after all of those business expense deductions.
How do you reduce your DTI ratio? Pay off your existing debts as quickly as possible and don't take on any new debt. The other alternative is to earn more money. You might also consider taking less business expense deductions from your taxes to increase the net income shown on those tax returns, although that means paying higher taxes.
Qualifying for a Loan
Given all the hoops self-employed borrowers must jump through to get a loan, you might think that they have to apply for special loans specifically designed for business owners and freelancers, but this is not the case. The self-employed are eligible for all or almost all of the same mortgage loans that are offered to employees for real estate purchases. That means you can work with a number of different lenders to see if you qualify for their loans. This includes Fannie Mae, Freddie Mac and the Federal Housing Administration.
There are also other alternatives you can try if you are turned down for a conventional mortgage. Some lenders offer nonconforming loans, also called nonqualifying mortgages (non-QM). Basically, non-QM loans are those that do not contain the protections required in the qualifying mortgage rule. After the housing crisis, the Consumer Financial Protection Bureau adopted this rule, requiring banks and other lenders to offer mortgage loans with stable features to make sure borrowers can afford the mortgages they were offered.
If a borrower cannot afford a qualifying mortgage, they can consider a non-QM loan. Non-QM loans have higher rates than the typical 30-year mortgage or come with higher closing costs and less favorable repayment terms.