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The Dos and Don’ts of Self-Employed Mortgages

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If you are self-employed, you have to meet different requirements than the standard borrower. You probably don’t have paystubs or W-2s to provide the lender with to verify your income. Instead, you have your own paperwork, probably completed by yourself to provide the lender. As you can probably see, this is a conflict of interest, forcing lenders to ask for other documents when you work for yourself.

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Keep reading to learn the top dos and don’ts of getting a mortgage when you work for yourself.

Do Keep Careful Records

If there’s one thing that can help you as a self-employed borrower, it’s records. The more records you have, the more proof you have that can afford a loan. Lenders often ask for the last two years of your tax returns, but if you have more to provide, it could work to your benefit.

If you have an accountant or tax professional taking care of your books, you could be in an even better position. They will have a year-to-date Profit and Loss or other financial paperwork your lender may need. What you are trying to prove is that you have a steady stream of income that the lender can see rather than just a total on your tax returns.

You want to paint the picture of reliability and consistency, which careful records can do for you.

Do Start Planning Early

As a self-employed borrower, you should try to plan for the purchase at least two years ahead of time. Lenders are going to need your tax returns for the last two years. If you write off a large number of expenses on your tax returns, your bottom line will be lower than you actually make. This will work against you when you try to qualify for a mortgage.

If you plan ahead, you can minimize your write-offs for the time being. Let your adjusted gross income be higher for those two years. Yes, you will pay more in taxes, but you will be rewarded by qualifying for the mortgage you need to buy your home. Once you are in the home, you can go back to your write-offs, lowering your tax liability and even enjoying the write-offs of owning a home.

Do Pay Off Debts

Self-employed borrowers are already a higher risk than the traditional borrower. In order to make up for this risk, you need compensating factors. A low debt ratio is one of the best compensating factors you can provide.

If you have the money to pay your debts off completely, you put yourself in a better position. Of course, if you don’t have the money to pay them off in full, at least pay your debts down. Lowering your credit card debt as much as you can will help your debt ratio. The lower the minimum monthly payment is the lower your debt ratio, which puts you in a better position.

Do Have a Large Down Payment

Again, because you pose a higher risk being self-employed, the more money you can put down on the home, the better. While you can borrow as much as 95% on a conventional loan and 97.5% on an FHA loan, it’s not recommended for someone working for themselves. The lender needs to know that you have a vested interest. This way they have more assurance that you will pay the loan back.

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There isn’t a specific minimum amount self-employed borrower’s need for a down payment. The more you can put down, the better your chances of approval, though. It goes back to the compensating factors. A higher down payment means less risk for the lender.

Don’t Damage Your Credit

Pay close attention to your credit score during the years leading up to your loan application. Opening your own business can be expensive and sometimes can damage your credit. Take your time building your business and only borrow what you can afford to pay back.

If you know you did damage to your credit score, try to get it back up again. Pay your bills on time, lower your outstanding debts, and don’t overextend yourself financially. You should also avoid applying for any new credit during the year or two leading up to the mortgage application. This will help increase your credit score and show the lender financial responsibility.

Don’t Deposit Large Amounts of Money

As a self-employed borrower, your lender is going to pay close attention to your bank statements. If you do make any large deposits, make sure you have proof of their origination. For example, if a vendor owed you a large amount of money and they finally paid you, don’t just deposit in your account and not keep a copy of the check from the vendor and the deposit ticket.

Lenders are going to see the large deposit, sending up a red flag. If you have proof and an explanation for the deposit, they may allow the use of the funds. If you cannot provide proof of the payment, the lender will likely exclude the funds from those you can use for the home purchase.

Don’t Become Self-Employed Right Before Applying for a Mortgage

If you are employed now but are thinking of jumping ship and opening your own business, don’t do it within two years of buying a home. Lenders want reliability and consistency, which they need two years of paperwork to determine.

Lenders need to see that you have the experience and knowledge to succeed in the business. If you start a business 6 months before you apply for a mortgage, the lender has no history to use when determining your consistency and reliability.

Two years is the ideal length of time you should be looking for self-employed for before applying for a mortgage, but if it’s slightly less, you can try if you have compensating factors as discussed above.

Getting a mortgage as a self-employed borrower isn’t impossible, but it does require more work. The better you set yourself up beforehand, the more likely it is that you will get the loan you want. Use these tips to help you situate yourself for success.

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Can you Buy a Home Without Proof of Income?

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If your income is rather sporadic or you don’t have paystubs/W-2s to prove your income, it may be hard to get a mortgage. Prior to the housing crisis, lenders were very lenient with who they lent money to for a mortgage. Today, it’s a different story. The housing crisis killed the idea of accepting any type of mortgage without proof of how you will pay for it.

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It all comes down to the Qualified Mortgage and Ability to Repay rules. The Qualified Mortgage Act requires that lenders make sure applicants meet certain requirements before they can take out a loan. The rules are strict, which means fewer borrowers will qualify. In exchange, however, lenders are protected from lawsuits should a borrower default on their loan and lose their home.

Not all lenders follow the Qualified Mortgage rules, though. They choose to take a chance and allow less stringent guidelines. However, no matter what a lender decides, they have to follow the Ability to Repay Rules. Basically, this means the lender can prove beyond a reasonable doubt that you can afford the loan. In other words, they need proof of your income.

Don’t worry, though, there are ways around it. You don’t have to be the paystub and W-2 employee to get a mortgage. There are other ways you can prove your income and still get a loan.

Use Your Tax Returns

If you are self-employed, lenders will need to see your tax returns. They’ll usually ask for two years’ worth of tax returns. This allows them to see your income over that time and take an average. It also allows them to see what expenses you write off, as they will take those expenses right off your income as well.

Your expenses are one area that your tax returns could hurt you. Even though it’s perfectly legal to write off certain expenses to lower your tax liability when you own a business, it could hurt you when you apply for a mortgage. Lenders are required to use your net income reported on your tax returns, not the gross income you claim. It’s to your advantage to hold off on writing off those expenses in the year or two before you know you will apply for a mortgage.

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Use Your Bank Statements

If your tax returns won’t yield the greatest results when you apply for a mortgage, consider using your bank statements as proof of income. This works well if you are self-employed or even if you work for someone but are paid commission or bonuses.

Your bank statements need to show consistent deposits in order for the lender to use the income as you state it. Regular deposits at the same time each week, every other week, or month will show the lender the consistency of your income. Lenders often use this money at the value of the deposits unless there is a reason to deduct unreimbursed expenses.

You’ll Need Compensating Factors

No matter which category you fall into, you’ll need to show the lender that you have compensating factors. For them to take your loan at face value without standard proof of your income is a big risk for them. In order to offset this risk, they need to know that you are a financially sound risk. You can prove this by:

  • High credit score – The higher your credit score, the financial responsibility you show the lender. Try increasing your score as much as possible during the time leading up to your mortgage application. The lower your credit card balances, and the more timely your payments, the better your score will be.
  • Low debt ratio – The lower your debt ratio, the lower risk you pose to a lender. If a lender is willing to take your alternative form of income, they want to know that you are not overextended on your debts. Staying below the program maximums will help your chances of approval.
  • Stable income – It’s hard to have stable income when you work for yourself or on commission, but making it as stable as possible is important. However, there are ways to prove stability even before you started your own business. The more experience you have in the industry you open your business in, the more reassurance it gives the lender that you are a good risk.

Proof of income is a vital component of the approval process for a loan, but there are ways around the ‘normal practices.’ You’ll need to find a subprime or alternative lender that is willing to think outside of the box, though. Your big box banks are going to have the stricter guidelines when it comes to income. It’s the smaller banks that have the ability to make their own rules because they keep the loans that will suit you best in this case.

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Fannie Mae Tax Transcripts Requirements

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Fannie Mae Tax Transcripts Requirements

Tax transcripts are official transcripts obtained from the IRS. The use of these transcripts is to verify that the tax returns you provide to a lender are legitimate and not altered in any way. There are certain situations when the transcripts are required and also certain situations when the lender does not have to execute the IRS Form 4506, but may choose to do so in order to satisfy their own requirements since it is their right to add their own overlays onto the standard Fannie Mae requirements.

When are Tax Transcripts Required?

Tax transcripts are necessary whenever you need to provide your tax returns to qualify your income for a mortgage. This includes borrowers that are self-employed, work on commission, or get a great deal of overtime in addition to their regular salary. If you want this type of income included in your qualifying income, tax returns are necessary in order to qualify. If you must provide full tax returns, Fannie Mae requires that the lender verify those tax returns with the IRS. Form 4506 helps the lender obtain a transcript and compare it with the tax returns you provided to them at the time of application for the loan. If the amounts match, the loan can close as planned. If the amounts do not match, however, further verification will be necessary. Following are the circumstances that would warrant a lender to ask for your tax returns:

  • Commission income that totals more than 25% of your regular income
  • Income you receive from a family member that is also your employer (family owned business)
  • Income from a rental property if you use it for qualification purposes
  • Seasonal income
  • 1099 income
  • Interest income
  • Self-employment income that totals more than 25% of your income
  • K-1 income

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When are Tax Transcripts not Required?

Not every self-employment or commission situation will require tax returns or tax transcripts. The basic rule is that this type of income must make up at least 25% of your income in order for tax returns to be required. For example, if you work overtime, but the income does not equal 25% of your regular income, it can be verified with your paystubs and W-2s alone. The same is true for self-employment income that you may have on the side or commission income that your employer pays you. Other types of income that do not require tax returns or tax transcripts include:

  • Social security income
  • Military income
  • Disability income

Any of these types of income can be verified using W-2s and paystubs or a letter from the party providing the income on their letterhead along with bank statements to show receipt of the income.

Not a Pre-Closing Concern

Form 4506 must be executed, but it is typically not a condition to close the loan, unless there is reason to suspect that the borrower’s tax returns are not legitimate. Every lender can use their own judgment when it comes to determining if a borrower is legitimate or not. If the income is determined as legitimate, the lender is required to execute the 4506 at closing. In addition, you sign a document at closing stating that everything is accurate and true that you provided on your application.

What do Lenders Look at Tax Returns For?

You might wonder why lenders require tax returns in the first place. It makes sense if you do not have paystubs or W-2s to document your income, but what about the cases where you do have those documents, such as commission income or overtime income? Why is there the double requirement to verify your income? The answer is simple – the lender needs to determine if there are any unreimbursed expenses that you pay in order to hold that job. Fi there are such expenses, they must be deducted from your income and/or included in your monthly debt ratio.

This requirement is only put in place when you have self-employment, commission, or overtime income that exceeds 25% of your income. If this income does not exceed that amount, the expenses are not required to be included in your debt ratio or deducted from your income. In most cases, if you have self-employment on the side or you work on commission but only slightly, the debts you incur will report on your credit report, enabling the lender to include it in your debt ratio anyways.

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Rental Income

Not all rental income situations require you to provide tax returns and tax transcripts. If you obtained the rental property after completing your most recent tax return, it will not report on there, but you are still eligible to apply for a mortgage. In these cases, you simply must report the rental on your mortgage application, along with any loss or profit you make in regards to the property. The lender will likely be able to figure out the debts you incur for this property based on your credit report, helping the lender make a sound decision when it comes to your loan application.

Tax transcripts can take a while to come into the lender, so if you know the lender will require them, ask for the forms to be executed as early as possible. In most cases, lenders wait until the closing to execute the document, since Fannie Mae requires them as a part of the post-closing package the lender sends to them. You have nothing to fear if tax transcripts are required as long as you provided accurate tax returns to the lender. Any type of fraud will be uncovered with the tax transcripts, so it is not worth taking a chance with the process. In general, transcripts do not hurt your case when it comes to applying for a loan – as long as you are open and honest and let the lender include all expenses/income in your application in order for the lender to create the most accurate picture of your financial situation.

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