Do you count yourself among the nearly 60 million Americans who are self-employed? Being your own boss has long held wonderful benefits — flexibility in working hours, freedom in choosing projects/co-workers, control over work environment, ability to pursue your interests/ obtain skills and more. But it also has its downsides.
Generating and proving a steady stream of income is often the biggest challenge, especially when trying to finance a significant purchase such as a car or home. While we are not prepared to give advice on generating revenue, paying for health insurance, saving for retirement or other challenges of the self-employed, we can guide you through the mortgage process.
Application process is the same
Self-employed individuals go through the same application process as everyone else and lenders consider the same things: your credit score, outstanding debt, assets and income, applying the same standards to each applicant. Similar to a W-2 applicant, most mortgage lenders require at least two years of steady employment to consider the income stream in determining qualification for a loan. This will likely include providing two-years of personal tax returns, two year of business tax returns (unless you are a sole proprietor), a year-to-date profit and loss statement, and a balance sheet.
Sometimes one year of self-employment plus a two-year history in a similar line of work is acceptable, however, you will need to document an equal or greater income in the new role compared to the W2 position. Some lenders will even count one year of related employment plus one year of formal education or training as an acceptable work history.
Employment verification is more burdensome
Proving that you are self-employed does require more paperwork. It could include emails or letters from the following:
· Current clients
· A licensed certified personal accountant (CPA)
· A professional organization that can attest to your membership
· Any state or business license that you hold
· Company insuring your business
Unsteady income requires explanation
If your income is not regular and reliable, a lender might require more than two years’ worth of tax returns to prove your income stability. Expect to provide three, four, or five years of tax forms and a statement from your accountant to show how your business handles cyclical trends. Think of the real estate developer who buys a property, pulls permits and begins construction in one year but doesn’t sell anything until the following year. This normal pattern can be proven with a five year look at the business profit and loss statements.
Only taxable income is counted towards your loan qualification
Business owners and other self-employed workers deduct as many expenses as they can to minimize income taxes. Unfortunately, this lower “taxable income” is what underwriters use in determining your loan qualification (there is typically an adjustment for non-cash items such as depreciation). For instance, you bill your clients $6,000 a month. But after deductions, your taxable income is only $4,000 per month. The impact on your home buying power is shown in this chart below (source: themortgagereports.com):
Bank Statement Loan is an option
Replacing the “no income verification” loans available before the housing market crash of 2007-8, these loans enable a borrower to rely on the cash generated from a business to qualify for a loan. Using 12 – 24 months of business and/or personal bank statements, the underwriter will analyze cash flows to determine a qualifying income stream. Expect these loans, however, to come with higher rates as they are considered non-qualifying and are generally riskier to the lender.
If you have any questions, or would like a mortgage broker recommendation, please give us a call. We work with several that consistently deliver in the most unusual situations!