If you are self-employed, you have a lot of flexibility when it comes to many things, including how your income looks on paper. Most people take advantage of the opportunity to write off every expense and take every deduction they can on their taxes year after year. While this might help you to reduce your tax liability and save you money in the long run, it can hurt you when it comes time to apply for a mortgage. If you are self-employed, it is very important that you plan for the future so that you can have an easier time obtaining a standard mortgage, rather than having to go the alternative documentation route.
What do Mortgage Lenders Want?
Basically, mortgage lenders need to see that you make money on paper. It is not enough to say that you bring in $100,000; you have to show it on paper and not just your bank statements. Lenders need FULL documentation for conventional loans and to meet the Qualified Mortgage Guidelines. This usually means that you have to provide paystubs and W-2s, but since you are self-employed, they will require tax returns with every schedule that you file.
How Tax Returns Hurt You
You might wonder how your tax returns could possibly hurt you; after all, you report your income accordingly. While this might be true, lenders have to look at the bottom line – the income you report and pay taxes on. Chances are, since you are self-employed that the bottom line number is not the number that you actually bring in. This is the number lenders use for your qualifying purposes. This means that if you report a loss, the lender uses the negative income to calculate your debt ratio, which it goes without saying, will not get approved.
How do you Work Around It?
If you want to take advantage of the low rates that conventional loans offer and avoid the higher rates and costs of alternative documentation loans (bank statement loans) require, you will have to plan accordingly. Lenders use the prior two years’ worth of tax returns to calculate your qualifying income. If you plan far enough in advance, you can avoid taking as many deductions and writing off as many expenses so that your tax returns are a more accurate reflection of the money you bring in on a yearly basis. Yes, this probably means paying more taxes for those few years, but if it helps you get a more affordable mortgage, it can be worth it.
Remember that lenders will need the last 2 years’ of tax returns. If you have one good year, but the year prior to that reported a loss or very low income, the lender will take an average of the 2 years. If this average is not high enough, you will not qualify. They do this in order to account for the lows and highs that you go through as a self-employed person. If your company provides products or services that are seasonal, chances are your income is cyclical, which means high at some points and low at others. Lenders need to make sure they are accounting for those low periods, which is why they take an average.
The earlier you start planning for a mortgage when you are self-employed, the more likely it is that you will be able to get approved for a conventional loan. Work with a lender or your tax accountant to figure out the way to work it out with your income so that when the time comes to apply for a mortgage, you are able to get the low interest rate and terms that you can feel good about.