Self-employment has many perks including making your own hours and working on your own terms. You probably even have control over the amount of taxes you pay thanks to the plethora of tax write-offs available to you. When you want to purchase a home, however, being a self-employed borrower has its own stipulations that might make the process a little tougher for you.
Tax Returns Speak Volumes
Anyone that works for themselves cannot provide any other income documents other than their tax returns if they want a conventional or government-backed loan. This goes back to the tax write-offs. Lenders take your bottom line income – not your gross income. If you take a large number of deductions, they come right off of the top of your income.
These deductions can include things such as:
- Retirement plans
- Medical insurance payments
- Business meals
- Travel expenses
- Vehicle expenses
- Large non-recurring expenses
The net income you show on your tax returns is the figure the lenders will use to qualify you for a loan. They do not see eye-to-eye with the IRS when it comes to legally reducing their income. A business expense is an expense, which means it takes away from your income. You can think of it like your personal expenses that get figured into your debt ratio in order to determine your eligibility. Because there is not a business debt ratio, lenders use your income after your business expenses.
Some lenders do add back certain expenses, including depreciation and expenses that you can prove were non-recurring. This is the exception to the rule when looking at your bottom line income.
Planning as a Self-Employed Borrower
Everyone needs to plan before purchasing a home, but as a self-employed borrower, you need to plan for a little longer. Typically 2 years ahead of time, you should start working towards your goal. The number one place to focus is your tax returns. What types of expenses do you write off? Does it really hurt your bottom line? If so, it is time to scale back on some of those deductions. After you close on your loan, you can start deducting those expenses again.
You should also start saving money ahead of time. You will need the standard down payment on government loans, such as 3.5% on an FHA loan, but you might need more on a conventional loan. There is a Fannie Mae program that allows for just a 3% down payment, but being self-employed might make you too risky for this program. Lenders like to see larger down payments when there is a significant risk in your file. Self-employment is that big risk, so the more money you have to put down, the more compensating factors you provide the lender.
Other ways you can plan ahead deal with your personal finances. If your credit scores are low or even borderline, start working to build them up. If you have a lot of outstanding debt, start paying it down. If you had some late payments in the past, start making your payments on time for the next 12 to 24 months. Each of these actions will help to increase your credit score.
Let’s take a look at two examples:
- Joe owns his own business and his net income is significantly lower than what he brings into his household income. He did, however, plan ahead and save enough money to put 20 percent down on the home he wishes to purchase. His debt ratios fall into line with the standards, 28/37, and he has been self-employed for 5 years. John has a credit score of 720, as well. Although his income is risky, he shows many compensating factors and he has a lot invested in the home with the 20% down payment.
- John also owns his own business. He has only owned it for 2 years, though. John did not have a lot of opportunity to save for a large down payment since he just opened his business, so he has 10% to put down. John’s debt ratios are also a little higher because of the many expenses he has for starting the business that leaked into his personal finances – his debt ratios are 29/41. John’s credit score is a little lower too; he shows a credit score of 690 right now.
Between the two examples, lenders would look at Joe more favorably because of the number of compensating factors he has including the higher credit score. Lenders will not base the eligibility on the credit score alone; however, they look at the big picture to see how everything fits together.
Keep your Income Increasing
It’s pretty obvious that lenders do not want to see income decreasing year over year. It is acceptable to have a slight decrease, but anything drastic will hurt your chances for a mortgage. Trying to time your mortgage application after two years of steadily increasing income will work to your benefit. This does not mean the entire year has to be on the upswing – every business has its peaks and valleys. Lenders take a 24-month average of the income from your tax returns; as long as that second year’s bottom line is slightly higher than the previous year, you show an increase.
Buying a home as a self-employed borrower is not as hard as it seems. The biggest hurdle is the amount of time you need for planning. You need extra time to figure out your tax situation and to have plenty of money saved for a down payment. Aside from that, everything else remains the same as a salaried borrower – you need good credit, low debt ratios, and steady employment, whether or not it means working for yourself.
If you are self-employed, it works best to shop with different lenders to see who has the best program. Some lenders are more lenient than others, so you can see which programs will work to your benefit as well as which will save you the most money every month.