The self-employed borrower faces a much larger obstacle when calculating income for mortgage approval than the salaried borrower. Lenders are inherently tougher on those that work for themselves. It’s likely due to the housing crisis and the numerous loans that defaulted because of the lack of income verification.
Whatever the reason, today’s borrowers working for themselves have a few hurdles they must jump through before qualifying for a mortgage.
It’s certainly not that it’s impossible. You just have to prepare yourself for more paperwork and required documentation than others.
Using Your Tax Returns
The most important document self-employed borrowers can give lenders is their tax returns. Keep in mind, this is not just your 1040. The lender needs all schedules of your tax returns. You’ll see why below.
From your tax return, a lender will take your ‘net business income.’ This differs from the salaried employee. Lenders who are paid by an employer get to use their gross monthly income for qualifying. Here’s an example:
John works for ABC Company and gets paid a salary. His W-2s for the last 2 years show that he made $50,000 per year. His lender will use $50,000 per year or $4,167 per month for qualifying income.
If John owned his own company and claimed that his gross yearly income was $50,000, but only claimed $40,000 on his tax returns, the lender would use $40,000 per year for starters. They would add back certain expenses, such as depreciation and amortization though. Unfortunately, John would not be able to use the full $50,000 salary for qualifying.
Lenders do not add back expenses you write off, such as cell phones, meals, travel, or vehicle expenses. They will also take a 2-year average of your self-employment income. For example, if two years ago you had $30,000 in net income and last year you had $42,000, the lender would average the 2 years to come up with $3,000 per month rather than $3,500 if the lender just used last year’s income.
If you have declining income, it could pose a problem for your loan as a self-employed borrower. In this case, the lender will not take a 24-month average. Instead, they will take an average of the last year. Here’s an example:
John made $70,000 two years ago. However, last year, he only made $40,000. This is a pattern of declining income. The lender will not give him the benefit of using the $70,000 income, as it will increase his average. If the business continues to decline, he could get qualified for a mortgage that he would not be able to afford.
Instead, the lender would use just the $40,000 income, using $4,000/12 = $3,333 per month as qualifying income.
So you can see the difference, if he were able to use the $70,000 income, his 2-year average income would equal $4,583.
Many lenders will not write a loan for a self-employed borrower with a history of declining income, though. You may have to shop around to find a willing lender. It also helps if you have compensating factors, such as a high credit score and low debt ratio. This helps offset the risk of your business with declining income.
Down Payment Funds and How It Affects Eligibility
One other aspect of your business income lenders will evaluate is your down payment funds and where they originate. If you can prove the funds come directly from your personal account, it may not affect your business income or chances for approval. You will, however, have to prove that the assets are completely separate from the business. In other words, it’s money you set aside through the years rather than money you recently took from the business.
If the funds do come from your business, the lender will evaluate the status of your business. They will need to see asset statements for your business to determine its worth. They will then determine if the funds you took compromise the business at all. If you took more than half of the business’ assets, it could put the business at risk. If, instead, you only took 25% of the business’ assets, it may not be as big of a deal.
Each lender looks at the situation differently, so you may have to inquire with several lenders.
The bottom line is that lenders look over self-employed income very carefully. They do not use the income you make before expenses. They can only use the net business income you claim on your taxes. They will order your tax transcript to make sure the information you provide them is the same information you gave the IRS.
It’s not impossible to get financing when you work for yourself, but it does require a little more work. A lender may even ask for proof of your experience in the industry just to judge your ability to keep the business afloat. Answering the underwriter’s questions and request quickly will give you the fastest answer when it comes to qualifying for a loan as a self-employed borrower.