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To qualify for a mortgage while being self-employed, there are a few key steps to follow:
1. Show proof of income: Provide tax returns, bank statements, and financial statements to demonstrate your earning capacity and stability.
2. Build a strong credit history: Maintain a good credit score by paying bills on time and reducing debt.
3. Save for a down payment: Save enough money for a down payment, typically around 20% of the home’s value, to show financial responsibility.
4. Keep accurate and organized records: Maintain organized financial records, such as profit and loss statements, to prove your income and business stability.
5. Work with a knowledgeable lender: Choose a lender experienced in working with self-employed individuals who understands the unique challenges and requirements.
6. Consult with a mortgage broker: Consider working with a mortgage broker who can help navigate the lending process and find the best options for your specific situation.
By following these steps, self-employed individuals can increase their chances of qualifying for a mortgage and achieving their homeownership goals.
Being in charge of your own work may seem like the ultimate freedom, but there are definitely disadvantages to being self-employed, especially when it comes to getting a mortgage as a first-time homebuyer. As a self-employed individual, you will face various challenges and the lender may offer you a higher interest rate. However, understanding the process and taking certain steps before applying can increase your chances of success.
Verifying Income When Self-Employed
An increasing number of individuals are now classified as self-employed. This includes business owners, as well as independent contractors, freelancers, and gig workers. Self-employed individuals often encounter more difficulties in obtaining a mortgage compared to those with a regular paycheck and W-2 form. This is because lenders find it harder to trust reported income from self-employed borrowers.
To address this, lenders impose stricter rules for self-employed borrowers. The key to a smoother and faster mortgage approval process is to understand what the bank requires. By coming prepared with the necessary documentation, you significantly improve your chances of securing a loan.
Proving Steady Income When Self-Employed
Lenders have specific criteria when evaluating borrowers. They want to see:
- A high credit score indicating a history of timely bill payments.
- Adequate cash or liquid assets to cover the down payment, escrow fees, and other closing costs.
- A history of stable employment with sufficient verifiable income to qualify for the loan.
It’s this last factor that often poses challenges for freelancers. The requirement for stable employment and verifiable income can be problematic for self-employed individuals. It is important to note that individuals who recently transitioned to gig economy jobs may find it difficult to obtain a loan. Lenders prefer borrowers who have been working for themselves for a longer period of time and earn a higher income compared to the average borrower.
Even for individuals with a steady paycheck, lenders prefer those who have worked in the same field for at least two years. While not a strict rule, this two-year work experience requirement applies even more strongly to the self-employed. If your new freelance work is in a similar field as your previous employment, such as a writer who freelances for different business websites, you may have a better chance. However, if you switch from being a freelance cook to driving for a ride share service, the bank may question the stability of your work history and may be hesitant to provide a loan.
One challenge faced by self-employed individuals is their income level. Freelancers’ income tends to fluctuate more from year to year compared to that of employees. Moreover, self-employed individuals often take full advantage of the tax deductions available to them for business expenses on their federal tax returns. Utilizing these deductions can significantly reduce their net income, which is beneficial for income tax purposes. However, this reduced net income may drop to such a low level that it disqualifies them from obtaining a mortgage.
Providing Documentation for Self-Employed Income
Lenders protect themselves by requiring additional documentation for self-employed individuals when applying for a mortgage loan. The specific requirements for documentation can vary among lenders, so it is advisable to consult a specific lender before preparing an application.
Unlike salaried employees who can prove their income by providing W-2 forms, which are prepared and sent by their employers to the government, self-employed borrowers do not receive W-2 forms and cannot use them as proof of income. Instead, they will need to provide two or more years of 1040 tax returns, including all schedules, as well as business tax returns (if applicable), balance sheets, a list of existing debts and assets, and similar documents. Additionally, a year-to-date profit and loss statement and a business license may also be required.
Lenders expect to see an increase in the self-employed individual’s income from year to year, rather than a decrease. If the most recent tax return shows lower income than the previous year’s return, the lender will not average the net income from both returns for loan purposes but will solely consider the most recent one. In fact, significant decreases in income shown in recent tax returns may lead to disqualification as it may indicate a declining business.
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Obtaining a Mortgage with a High Credit Score
A self-employed individual must take every possible step to present themselves as a strong candidate for a loan, including improving their credit score. Credit scores are calculated based on factors such as payment history, overall debt level, number of credit accounts, and balances for those accounts.
Both employees and self-employed individuals need a good credit score to qualify for a loan, and an excellent score is required for a low-interest loan. As you start considering buying a home, it is essential to check your credit score, which can be done at any of the three main credit bureaus: Equifax, Experian, and TransUnion. Additionally, you can obtain a free credit report from each of these bureaus once a year.
Credit scores range from 300 to 850, and generally, a higher score increases the chances of obtaining a home loan. Individuals with scores between 720 and 850 are considered reliable borrowers and have access to the best loans. A score of 800 to 850 is deemed excellent and can help overcome obstacles in securing a loan. As a self-employed individual aspiring to become a homeowner, improving your credit score can enhance your chances of getting a home loan. This can be achieved by making timely payments on credit cards and other recurring expenses, avoiding overdrawing your bank account, reducing debt, and maintaining a zero balance on unused credit accounts.
Save for a Substantial Down Payment
Most people purchasing real estate do not have the full purchase price in cash. Instead, they use a down payment to cover a portion of the purchase price and finance the rest through mortgage loans. Ideally, lenders prefer a down payment of at least 20% of the purchase price, which equates to $20,000 for every $100,000 of the price. However, some lenders, such as the Federal Housing Administration, accept a smaller down payment as low as 3.5%.
Self-employed homebuyers can improve their chances of getting a mortgage by saving for a substantial down payment. To qualify for a real estate loan, they will likely need a down payment of at least 20%. However, considering the challenges faced by self-employed borrowers, aiming for a 25% or even 30% down payment is advisable. Having more liquid assets increases the likelihood of securing a mortgage. Lenders also expect additional cash flow to cover closing costs and home maintenance expenses.
Understanding Debt-to-Income Ratio
Debt-to-income (DTI) ratio is a significant factor in a lender’s decision-making process for home loans. DTI compares a borrower’s total monthly debt payments (credit cards, car loans, student loans, etc.) to their monthly income. For example, if someone earns $4,000 per month and their total monthly debts amount to $2,000, their DTI ratio is 2,000/4,000, or 50%.
Lenders prefer the DTI ratio, including the new mortgage payments, to be no more than 43% of the monthly income. This means that if an individual earns $4,000 per month, their monthly payments, including the new mortgage, should not exceed $1,720. By calculating all monthly debts and subtracting that amount from $1,720, you can determine the affordable mortgage amount.
Having a DTI ratio of 43% or lower can be challenging, especially for those with numerous outstanding debts. It is even more difficult for self-employed individuals. While banks allow employees to use gross income (income before deductions) for their DTI ratio, self-employed borrowers must use the income remaining after deducting business expenses.
To reduce the DTI ratio, pay off existing debts promptly and avoid taking on new debt. Increasing income is another option. Additionally, self-employed individuals can consider minimizing business expense deductions on their tax returns to show higher net income, although this may result in higher taxes paid.
Meeting the Requirements for a Loan
When it comes to obtaining a loan, self-employed individuals may believe that they need to apply for specialized loans that are specifically tailored for business owners and freelancers. However, this is not the case. Self-employed individuals are actually eligible for the same mortgage loans that are available to employees for purchasing real estate. This means that they can explore various lenders to determine if they meet the criteria for their loans. These lenders include Fannie Mae, Freddie Mac, and the Federal Housing Administration.
If a conventional mortgage application is rejected, there are alternative options that can be considered. Some lenders offer nonconforming loans, which are also known as nonqualifying mortgages (non-QM). Non-QM loans are essentially those that do not adhere to the requirements outlined in the qualifying mortgage rule. Following the housing crisis, the Consumer Financial Protection Bureau implemented this rule, which mandates that banks and other lenders provide mortgage loans with stable features to ensure that borrowers can afford the mortgages they are offered.
If a borrower is unable to afford a qualifying mortgage, they can explore the possibility of obtaining a non-QM loan. However, it is important to note that non-QM loans typically have higher interest rates compared to traditional 30-year mortgages, as well as higher closing costs and less favorable repayment terms.
