Getting a Mortgage as a Self-Employed Borrower
Purchasing a home for the first time requires a great deal of preparation, and the process can be both exciting and terrifying. This, coupled with being a self-employed borrower, makes for an even more complex experience.
Self-employment has its rewards. You can set your own hours, control your income and perhaps avoid daily commutes. But even if you earn a decent living and you’re cognizant of basic mortgage requirements, your journey of getting a loan will differ from that of a person who receives a W-2.
A mortgage isn’t unattainable as a self-employed borrower, but you’ll face a unique set of challenges. Unlike an employee who earns a predictable wage or salary, your income may fluctuate from month-to-month or year-to-year. So it’s paramount that you’re able to show beyond doubt that your work and income are consistent and stable.
Here’s what you need to know when getting a mortgage as a self-employed borrower.
1. Must Provide Two Years of Personal Tax Returns, Business Tax Returns, and K-1's
Because you don’t receive a conventional paycheck from an employer or a W-2 , furnishing tax returns is the only way to substantiate your income.
Prepare to forward copies of your complete business tax returns for the previous two years, in addition to your personal tax returns, when applying for a mortgage. Depending on your business structure, you might also need to provide copies of your K-1 income tax form. This gives lenders a complete picture of your earnings. Ideally, your business income should remain approximately the same or increase from year-to-year. Some variations are to be expected, but for the most part, underwriters don’t want to see a dramatic decrease in income from one year to the next.
Even though two years of tax returns is the norm, some self-employed individuals can get a mortgage with only one year of business tax returns depending on the loan program — but only if the business has been in existence for at least five years. Additionally, some newly self-employed individuals may qualify with only one year of business returns, assuming they have significant previous experience within the field.
2. Prepare a Year-to-Date Profit and Loss Statement and Balance Sheet
Your tax return reveals how your business has performed over the previous two years. A balance sheet and your year-to-date Profit and Loss Statement, on the other hand, disclose your company’s performance for the year thus far.
This form — which summarizes income and business expenses for a specified period of time — can be put together by an accountant and essentially validates the current condition or stability of your business. This is necessary to ensure that the company is still profitable, and that it can provide you with sufficient income for a mortgage payment.
Keep in mind that a Profit and Loss Statement isn’t always required when getting a mortgage – it depends on your particular loan. Some mortgage programs call for these statements when self-employed borrowers put in an application for a mortgage after the first quarter of a new year.
3. Increase Your Credit Score
Similar to a non-self-employed borrower, you must authorize a credit check when applying for a mortgage. An analysis of your credit history helps underwriters discern your ability to pay back a mortgage.
You can acquire a home loan with a credit score as low as 620 for a conventional loan, and as low as 580 for an FHA loan. Even so, a higher credit score can make it easier to qualify for a loan as a self-employed borrower. A good credit score indicates a successful history of managing debt. This builds our confidence in your ability to handle a mortgage.
In preparation for a mortgage, check your credit report for errors. If you find errors, contact the three credit reporting bureaus (Experian, TransUnion, Equifax) to fix these mistakes. Correcting erroneous information on your report can increase your credit score.
Also, take additional steps to build a better credit score. Pay off as many debts as possible, especially credit card debt, and don’t apply for too many new credit accounts. Multiple credit inquiries can lower your credit score.
4. Maintain a Cash Reserve
Because self-employed income can fluctuate, some loan programs may impose a cash reserve requirement, where you’ll need a minimum of three months of mortgage payments in reserves. This is money remaining in your savings account after paying your down payment and closing costs.
This isn’t an industry standard but might be required if you’re a high-risk applicant (low credit score, high debt-to-income ratio, small down payment). To verify the availability of funds to cover mortgage-related expenses and meet any cash reserve requirement, you must submit copies of your bank statements, as well as statements for retirement accounts and other investments.
5. Authenticate the Existence of Your Business
As you apply for your first mortgage as a self-employed borrower, be prepared to provide third-party proof of your business existence. Acceptable proof might include a copy of your business license, copies of business bank account statements, a letter from your accountant or CPA, or perhaps a reference letter from an established client.
6. Limit Your Number of Business Deductions
Fortunately, you can write off many business-related expenses to reduce your tax liability. These include expenses for supplies, equipment, marketing, etc. But while business deductions can minimize your out-of-pocket costs at tax time, too many deductions are a huge disadvantage when applying for a mortgage.
The more business write-offs you have, the less money you make on paper. In other words, too many write-offs could lower your net income considerably, and reduce how much you’re able to spend on a home.
If you anticipate buying a house in the next couple of years, limit your number of business deductions for the next two years to increase your net income.
7. Fork Over a Bigger Down Payment
If a number of recent write-offs have resulted in a significant reduction of your net income — and you don’t want to put off getting a mortgage — aim for a 20% down payment, if possible.
This shrinks the amount you need to borrow, and you’ll also avoid private mortgage insurance (PMI). PMI is required on most mortgages without a 20% down payment. Eliminating this added expense increases purchasing power, helping you qualify for a bigger mortgage.
Ethos Lending is a new type of mortgage lender. We use technology to keep our operational costs as low as possible. From closing costs to interest rates, we have made it our mission to make the process of buying a home more affordable. Get in touch with one of our mortgage specialists to learn more.