If you’re self-employed, you’re probably at least somewhat aware that it’s more difficult to qualify for a home loan than it is for a salaried person. Whether it’s fair or not, lenders generally view salaried incomes as more secure than self-employment. For that reason, you’ll have to come up with a lot more documentation with your application. And you’ll probably need to be a little bit better qualified than most other borrowers.
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Here are some strategies to help you through the process.
Be Prepared to Answer a Lot of Questions
If you’re salaried, your income can be easily explained with a W-2 and your most recent pay stub. But when you’re self-employed, it’s never that simple.
You’ll have to supply a lot more documentation. You should generally assume that you’ll need to provide complete income tax returns for the past two years. Under certain circumstances, you might also have to provide a year to date profit and loss statement prepared by your accountant.
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You also have to verify how long the business has been in existence. This can often be done with a business license or verification of your incorporation in your state of residence. The lender may also want to verify the existence of your business with your accountant.
And if that’s not enough, they’ll have you sign IRS Form 4506, which enables the lender to get copies of your tax transcripts directly from the IRS. Lenders do this as a quality control measure to verify that the information in your tax returns is correct.
Good Credit is Preferred
Mortgage lenders will often accept borrowers with credit scores as low as 620. If you’re self-employed, good credit will be considered important. Since they already consider self-employment as a significant risk factor, making the loan if you have less than good credit could be a problem.
There’s no specific credit score minimum for self-employed borrowers. But it’s safe to assume that your application will be much stronger with a much higher credit score.
If nothing else, it serves to verify that you’re able to successfully manage your obligations on the self-employment income you’ve declared.
Your Business Can’t be New
As a general rule, lenders look for you to be in business for a minimum of two years. This is necessary to establish the stability of your business. If you can show that your business is profitable for at least two years, the lender can safely assume it will continue to be so.
Lenders will sometimes accept less than two years in business, but only if you can prove that you were previously employed in a similar business. That will show that you’ve been in the same line of work for at least two years.
You’ll Be Qualified Based on Your Net Business Income
This is a big misconception among the self-employed. If the gross receipts from your business are $100,000, but your tax return shows a net income of $50,000, you’ll be qualified on the $50,000 net, not the $100,000 gross.
The lender will add back intangible expenses, like depreciation and amortization. That should help your income number at least a little bit.
But they’ll also average your income over the past two years. For example, if you made $100,000 in the last tax year, and $60,000 the year before, your income will be determined to be $80,000 ($100,000 + $60,000 = $160,000 divided by 2).
There’s another issue here that can complicate the income calculation. Let’s turn the above example around. Let’s say you made $100,000 two years ago, and $60,000 last year. In that situation, the lender will almost certainly use $60,000 as the qualifying income.
That’s if they’ll even accept the income at all. Declining income can be an indication that a business is failing. If the declining income is steep enough, the lender may determine your income is not stable, and cannot be used to qualify.
If that’s the case, you may have to supply documentation showing that the decline was a one-time event. You may also have to document that your income is higher in the current year. This is where a lender may require a year to date profit and loss statement.
Failing this, you may have to make a larger down payment, or get a qualified cosigner for the loan.
Funds for Your Down Payment
In most cases, the lender won’t permit the funds for your down payment to come from a business account. You and your business are seen as separate entities. If a substantial amount of money withdrawn from your business for the down payment on the home, it can be viewed as an impairment of your business operations.
There may be certain documentation that can be used to get around this issue. But as a general rule, it’s best to make sure your down payment is coming from a personal bank account, and not a business account.
You Probably Won’t Be Able to Close Broke
Lenders sometimes require what is known as cash reserves. These are the liquid funds you will have available after closing. The idea is that cash reserves will act as a cushion, particularly in the early months of homeownership.
Cash reserves are usually expressed as a number of months of the payment on the new home. For example, if your mortgage principal, interest, taxes, and insurance (“PITI”) are $1,500 per month, and the lender requires two month’s cash reserves, you’ll have to have $3,000 in liquid assets after closing.
Once again, this is a condition that a lender may not require for a salaried borrower. But you should fully expect to have cash reserves if you’re self-employed. It’s another of those factors that lenders consider as reducing the risk of making loans to the self-employed.
There isn’t really a bias against self-employed borrowers in the mortgage industry. But there is a definite requirement for a greater level of documentation. You’ll be helping your own cause by supplying any documentation requested. You can still get your mortgage, but the burden of proof will just be a little bit higher.