What It Takes To Get A Mortgage When You’re Self-Employed

Debt to income ratioGetting a mortgage is tough enough these days, but it’s even more complicated – and frustrating – when you’re self-employed. This is because the mortgage industry prefers to give loans to people who are employed by someone else. There is a widely held perception that holding a job is a lot less risky than having your own business. It’s also much easier for lenders to document and evaluate income from a W-2 employee, than for the self-employed.

But if you are self-employed, you probably have some idea about this already. The real issue is how to get mortgage when you’re self-employed. There ways to do that, but it is admittedly more difficult than it would be if you have a salaried job. Nearly every aspect of your creditworthiness will be more carefully evaluated, and you have to be prepared to deal with it.

Your income

Here’s what mortgage lenders are looking for: that your business has been up and running, and profitable, for at least the past two years. They will also look for consistency of earnings over that two year period.

You’ll have to present, at a minimum, fully completed income tax returns for the past two calendar years. They may even request year-to-date financial statements – often audited – if you complete your application well into the current year when obviously no tax returns are available to prove your income.

The lenders will average your income based on the past two year’s income tax returns, and sometimes the year-to-date financial statements. If the documentation shows a trend of declining income, the lender will either lower your income or – more likely – decline the loan completely.

For the most part, your income will be calculated by taking the net income of your business (based on your income tax returns), and adding back depreciation, amortization, or any wages that you may have drawn from the business, if it is incorporated.

If you just started your business last year, or at the beginning of this year, don’t even bother applying for a mortgage. The lender will deem that you do not have a sufficient track record to be creditworthy.

Debt-to-income ratios

Mortgage lenders impose debt-to-income ratios on all borrowers. They just tend to be less lenient on the ratios when it come to the self-employed.

There are two debt ratios:

Housing expense ratio – This is sometimes referred to as the front-end ratio. It is calculated by dividing your primary housing expense – principal, interest, taxes, and insurance (or PITI) – by your stable monthly income. For example, if your stable monthly income is $5,000, and your house payment is $1,250 per month, your housing ratio is 25% ($1,250 divided by $5,000).

Total household debt ratio – Or simply debt-to-income ratio (DTI), is calculated by taking your primary housing expense and then adding all other fixed monthly expenses up as total obligations. This will include student loan payments, car payments, any other installment payments, revolving debt payments, and alimony or child support payments. It does not include monthly childcare, insurance and utility expenses. If your house payment is $1,250 per month, and all of your other payments come to $500 per month, your total monthly obligations are $1,750. By dividing $1,750 into your $5,000 monthly income, your DTI is 35%.

Historically, mortgage lenders have observed the” 28/36 rule” in regard to debt ratios. Up to 28% of your stable monthly income can be allocated for primary housing, and your total DTI is limited to 36%.

The usability of this rule has fluctuated wildly in the past 20 years. While it was once a hard and fast rule, use of computerized underwriting allowed those percentages to double. And with the advent of no income verification loans, debt ratios didn’t matter all. Now we’re largely back to where we started, at 28/36.

Though lenders may allow a DTI of 43%, they’re more likely to hold the line at 36% if you’re self-employed. The best recommendation is that you should payoff as much debt as it takes in order to get your DTI down to no more than 36%. Be sure you do this well before you apply for a mortgage, otherwise the next thing they’ll be interested in is how you did it. You’ll need plenty more documentation to prove that one.

Your credit history

If you’re self-employed, you’re going to need a better than average credit score. 680 is probably the minimum. Lenders may take borrowers with lower credit scores, but rest assured they won’t be self-employed borrowers. Better yet, make sure your score is at least 720.

Your assets

Since self-employment income is considered to be unstable by its very nature, your assets can be a major compensating factor. Lenders will typically look for at least two or three months of “reserves” with any borrower. In the mortgage industry, reserves are calculated based on how many months PITI you will have available after closing. That will be money that will enable you to make your mortgage payment in the event that you have a bad month or two.

For self-employed borrowers, it’s always best to have at least six months in reserve after closing. That will assure a nervous mortgage lender that you have the financial strength to make the payments when income is tight.

The down payment

Salaried borrowers typically have a better chance at qualifying for minimum down payment loans. But if you’re self-employed, you’re going to have to make more than the minimum down payment. You’ll have a far better chance of getting loan approval if you make a 20% down payment on the property, rather than 5% or 10%.

A higher down payment by you means less risk for the lender. And though lenders will accept gifts from family members for down payments of 20% or more, when you’re self-employed, it’s far better if those funds come out of your own bank account.

The income minimization payback sting

When you are self-employed, it’s only natural that you attempt to minimize your income for tax purposes. After all, the lower your income, the less you pay in taxes. That’s just good business sense.

But that strategy creates a nasty payback when you apply for a mortgage.

Mortgage lenders analyze your income based on the numbers presented in your income tax returns. The fact that you have pursued income minimization strategies – which are perfectly legal – will not encourage your lender to give you more latitude in calculating your income.

The point is, the taxes you spared yourself in minimizing your income, will hurt when you apply for a mortgage. This isn’t to say that you should abandon the strategy and juice your income by ignoring allowable deductions. But it might mean that you should be a little less aggressive with your taxes if you’re planning to buy a house.

The relationship between a borrower mortgage lender is somewhat adversarial by nature. But nowhere is that more true than for the self-employed. Know what you’re up against, so you can make the proper preparations in advance.

If you’re self-employed, what has been your experience in applying for a mortgage?

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2 Comments

  1. As I plan to leave traditional employment in 6-7 years, this is a great post to keep in my bookmarks. So thanks, Jim. Do you think that investment income (e.g. – dividends or sale of assets, or rental income) might be treated differently by a lender? We may want to purchase additional rental property even after reaching FI, so I’d like to set ourselves up for that.

    • MOST DEFINATELY! In order to use investment income, you’ll need to show a three year trend of positive investment earnings sufficient to carry the mortgage you are applying for as well as your other debts and obligations. The lender will officially say two years, but trust me, they’ll utlimately want three years. That means your income tax returns with all schedules.

      In addition to the tax returns, you’ll also need to prove sufficient assets to support your investment earnings. It will have to be reasonable too. Even if you are earning $100,000 per year on a $200,000 asset base, the lender will most likely declare that it doesn’t pass the reasonableness test.

      Also be aware that your asset base will be reduced by your down payment. The lender won’t ignore that and may reduce your investment income proportionately.

      Its doable but you have to be ready to jump through a bunch of hoops.

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