It sometimes seems as if the deck is stacked against getting a mortgage when you’re self-employed. More documentation is required, and it seems that the likelihood of being declined is higher than it is for salaried borrowers.
There’s at least a grain of truth in all of that. But it’s not as if mortgage lenders are discriminating against self-employed borrowers. It’s just that the income source for self-employed borrowers is considered riskier than it is with salaried borrowers. More than anything else, however, it’s mostly a matter of knowing how the process works, and what you need to do to get a favorable outcome.
In this article, we’re going to discuss the nuances of getting a mortgage when you’re self-employed. We’ll cover what lenders look for, and what you can do to satisfy those requirements.
We’ve already covered the technical methods by which income is calculated for business owners in How Mortgage Lenders Calculate Self-employment Income so we won’t go into deep detail on that.
Getting a Mortgage when You’re Self-Employed
Start-ups Need Not Apply
It’s unfortunate, but true, that if you recently started a business, you will not be able to get a mortgage. This applies to anyone whose business is less than one year old.
Mortgage lenders generally look for a minimum of two years of self-employment. This is required since it really takes at least that long to prove the viability of the business, as well as to document a track record of consistent earnings. Lenders will sometimes accept less than two years of self-employment – but never less than one – and only under very limited circumstances.
If it seems as if the lender is putting a greater burden on you than they would if you were a salaried borrower, it’s only because the likelihood of business failure is relatively high, particularly for a brand-new business.
It’s Never Your Gross Income…
Some self-employed borrowers are under the mistaken impression that their gross income represents their actual income. So if they have total sales of $100,000 in the most recent year, they may report their income as that amount.
But a lender is also concerned with the expenses that are written off against that income. After all, it’s those expenses that help to generate the gross income. But at the same time, business expenses reduce business income. It’s the net income – gross sales, fewer business expenses – that represent your actual net cash flow from the business. That’s the income that lenders will use to qualify you.
And they will average it over the past two years. In that way, a net income of $100,000 in 2016 and $60,000 in 2015 will be averaged to produce a qualifying income of $80,000. This is generally determined by looking at your completed income taxes for the past two years.
Once again, you can refer to How Mortgage Lenders Calculate Self-employment Income for the specifics on how that is done.
The Inherent Conflict of the Self-employed When it Comes to Income Taxes
Do you know how when you file your income tax return, the basic objective is to minimize your net business income so that you can lower your tax bill? It’s unfortunate, but that’s the exact opposite of what you’ll want to do when you apply for a mortgage. When applying for a loan, you’ll want to maximize your income.
That’s an inherent conflict. You can’t have it both ways – minimize your income for tax purposes, but present higher numbers for borrowing purposes. What helps with one (taxes), hurts with the other (borrowing). There’s no way to reconcile the two, but as a self-employed person, you need to be aware of this dilemma.
Mortgage lenders will allow you to add back non-cash expenses, like depreciation and amortization, to your income. But any other expenses deducted against your gross income on your tax return(s) will stick.
Watch Those Big Bank Deposits
You will be required to provide bank statements to verify that you have the funds for the down payment, closing costs, and any required cash reserves. The underwriter will review those bank statements, which generally cover the most recent two months, and look for any unusual activity. That can include large bank deposits. For example, if your bank has a balance of $10,000, and that includes a recent deposit of $8,000, the underwriter will request that you document the source of that deposit.
This isn’t something that will be required only of self-employed borrowers. Similar requests will be made of salaried borrowers as well.
What the underwriter is looking for in this situation is an undisclosed loan. For example, if your credit report was run on the seventh, and your bank statement shows a large deposit on the ninth, it could indicate that you took a loan that is not reflected on your credit report, or in your loan application. The documentation you provide will prove that the deposit does not represent a new loan.
Using Your Business for the Down Payment
For many small business people, particularly sole proprietors, there’s no real separation between their personal and business finances. They assume that if they need money for a down payment on a house, that they can simply take it out of their business.
The underwriter may disagree. The reason is that the underwriter must be concerned that the withdrawal of a substantial amount of money from the business, or a business account, can weaken the business to such a degree that the operation may be impaired.
In these situations, the underwriter will likely ask for a letter from your CPA, confirming that the withdrawal of funds from the business will not affect the business in a negative way.
Be Prepared for More than the Usual Amount of Mortgage Documentation
If you’re a salaried borrower, you typically need to provide nothing more than a recent pay stub, W2s for the past one or two years, and a couple of recent bank statements, to prove your creditworthiness. When you’re self-employed, the documentation list is a lot longer.
Some of the additional documents that the lender will request can include (and you should be prepared to provide):
- Your most recent two year’s personal income tax returns, signed and including all schedules
- Your most recent two year’s business income tax returns, signed and including all schedules
- A copy of your most recently filed business license (state, county, or municipal)
- A letter from your CPA verifying the start date of your business (if less than two years)
You should also be prepared to provide any additional documentation that will be necessary to address questions or concerns regarding any of the above documentation.
Always remember that while a salaried employee is a worker in a larger organization, you represent both the employee and the employer as a self-employed business person.
That’s the reason why more documentation is required.
Good or Excellent Credit is a Must
It’s common knowledge that the better your credit is, the more likely that you are to be approved for a mortgage, and the better the interest rate you are likely to get. But with self-employed borrowers, credit is just a little bit more important.
Since self-employment considered to be higher risk, a fair or poor credit rating would represent an added risk. Mortgage lenders don’t like loans that have multiple risks! For that reason, your credit should be in the good to excellent range. If it isn’t, do your best to improve your credit score before making an application.
The More Cash Reserves, the Better
There are few factors that make a self-employed borrower – or any borrower – look more sound than a healthy bank balance. Even if you’re making a large down payment on a home, it’s best to have plenty of money left over after closing. That will assure the underwriter that you are financially strong and very unlikely to turn into an early-term default.
If you’re self-employed borrower, it’s best not to plan to apply for a mortgage when you are buying a home on a shoestring. Make sure “the vault is full.” It will give underwriting more flexibility if your loan profile has other weaknesses.
Advance Preparation and Your Full Cooperation are Your Best Strategies
As a self-employed businessperson, your best strategy in applying for a mortgage is to be prepared for the application process in advance. That means knowing what documentation will be required and having it ready at the time of application.
You should also be prepared to fully cooperate if the lender requests supplemental documentation. When the lender does this, they are asking you to help them justify approving your loan. It’s in your best interest to cooperate fully.
The bar is higher for self-employed borrowers when it comes to applying for a mortgage. But by being fully prepared for that reality, you increase the chance of getting your loan approved.