What You Should Know about Getting a Mortgage When You're Self-Employed
There's a lot to be said for the freedom of self-employment. Setting your own hours. Determining who you work. Even where you work. But there can be some downsides, too, like the added difficulties you may experience when buying a home.
However, with the right preparation, getting a mortgage when you're self-employed can be a positive experience. To simplify the process, here are five things you should know before you start your home loan journey.
1. You Should Have Stable Income—And Proof to Back It Up
Just like any other borrower, you'll need to have enough income to support your mortgage payments and will be required to prove it.
However, your income will be under more scrutiny as a self-employed borrower. That's because self-employed borrowers are more prone to income fluctuations than borrowers who are traditionally employed. In addition, you probably won't have a W2 that easily shows how much you make. (Unless, of course, you qualify for and choose to pay yourself a salary instead of taking an owner's draw.)
If your income varies from year to year, a lender might worry that you may not have enough money some months to make your payments. This is the main reason why it's so important for you to have a stable, consistent income. It gives the lender confidence that you'll be able to pay them back.
Another thing that gives them confidence? Having the documentation that shows proof of your stable income. If you don't have a W2 you can produce, you will need to gather the following for your lender:
- 2 years of your 1040 tax returns with all schedules and, if you also file business taxes, 2 years of your business income tax returns
- 2 years of 1099 forms, if you don't file business taxes
- A copy of your business license or a letter from a certified public accountant (CPA) stating you've been in business for 2 or more years
- A profit and loss statement signed and dated by a CPA (some exceptions may apply)
- IRS form 4506-T
- Any other documents your underwriter may request
Based on these documents, the lender will calculate your average monthly income by adding the two years' total and dividing it by 24 months. The final number they come up with will then be used to determine your debt-to-income (DTI) ratio.
2. Your Tax Write-Offs Will Affect Your Debt-to-Income Ratio
Speaking of DTI, while you must meet the same standard (usually less than 39–43%) as a traditionally-employed borrower, how it's determined may be slightly different if you're self-employed. This difference in calculation could put you at a disadvantage.
For traditional borrowers with a W2, DTI is usually calculated based on their gross, or pre-tax, income. However, lenders usually calculate the DTI for a self-employed borrower using only their taxable income.
Where you might run into problems is that most self-employed people usually write off a bunch of deductions to legally reduce what they owe in taxes. While this is great come tax time, these write-offs work by reducing what lenders will consider to be your income.
Because DTI is calculated as your debts divided by your income, when you write off business expenses to reduce what's taxable, your DTI will increase. Here's an example:
Let's say your mortgage will end up costing you $1200 per month, plus you pay $250 for an auto loan and around $350 for your credit card bills. Your total monthly debt is about $1,800.
Now, in your business, let's say you are making about $6000 every month, but after all of your deductions, your taxable income averages out to be only $4,000. All of a sudden, instead of a DTI of 30% ($1800 ÷ $6000 x 100), you have a DTI of 45% ($1800 ÷ $4000 x 100).
With most lenders, a 45% DTI could disqualify you unless you are able to further prove your ability to repay the loan.
If you know you want to buy a home in the next few years, one way to overcome the DTI hurdle is to reduce your tax write-offs for a couple of years before you apply. That way, your taxable income for those years is recorded at a higher, more accurate amount, reducing your DTI.
3. You Should Keep Your Personal & Business Expenses Separate
Another way to negatively impact your DTI is by mingling your business and personal bills.
While it's normal for businesses to carry higher debt-loads, if you pay them off using a personal checking account or you charge them to your personal credit card, those business debts look like your personal debts and could be counted against you when your DTI is calculated.
In addition, using your personal cards for business expenses can also negatively affect your credit score, another important indicator used by lenders to determine your lending risk. Making large business purchases on your personal cards will drive up your credit utilization and drive down your score.
By separating your accounts, you avoid this unnecessary complication—plus, you’ll make it easier for lenders to determine your actual ability to repay the loan.
Finally, having separate business makes it easier to track your business's actual finances, providing a more accurate picture of how well your business (and, by extension, you) are doing. It will simplify your ability to keep clean records and provide any documentation your lender may require, including expenses, invoices, profits, and losses.
4.You Shouldn't Be Charged a Higher Interest Rate
There's a lot of misinformation out there about getting a mortgage when you're self-employed, and one of the most common is that self-employed borrowers are given a higher interest rate.
To put it simply, if all elements of your application are equal to those of a borrower with traditional employment—meaning your adjusted taxable income matches their gross income, you have the same debt obligations, and your credit scores are similar—you will not be penalized simply because you are self-employed.
The only time you might receive a higher interest rate is if you have a higher DTI, as this is a red flag for lenders that you're at greater risk of defaulting. Because of how loans are paid off, lenders often use a higher interest rate as a kind of insurance to protect their losses if you default.
Since a higher DTI is more likely to occur for self-employed borrowers (thanks to the adjustments on their taxable income), it may seem like being self-employed = higher interest. However, this is confusing correlation with causation.
A more accurate way to look at it would be to compare your loan rate to a borrower with the same DTI. When you do, you should see that your rate is competitive with theirs.
That being said, if you are given a higher interest rate than what you would like, just know that you may be able to refinance in the future. Once you have a solid history of on-time payments with your lender, they'll be more confident that your ability to repay is strong. They'll see you as less risky and, depending on what interest rates are doing at the time, could offer you a lower rate on a refinance.
Some other ways to reduce the likelihood of a higher interest rate include:
- Paying off debts before applying
- Maintaining a high credit score
- Making a larger down payment
- Having sufficient cash reserves to cover your payment during months of lower income
5. A Good Lender Will Guide You through the Process
If you're a self-employed borrower looking to purchase a home, it is possible for you to qualify for a mortgage.
Though there might be a few extra hoops to jump through, a good lender will be there with you every step of the way. They'll make sure the process is as simple and straightforward as possible.
At Elevate Mortgage, we're always here to answer your questions or help you get started, even if that just means supplying information for now. That's because there's never any obligation to lend with us when you call.