Getting a Mortgage When You're Self-Employed
Renters Warehouse Blog
While getting approved for a mortgage when you’re self-employed can prove to be a bit more challenging, it’s certainly not impossible. There are just a few more hurdles you’ll need to jump through compared to your W-2 counterparts.
This is because the banks view self-employment income as riskier and more unpredictable. Because of this, they’ll require specific documentation to ensure that your income is stable before they lend you any money.
To help make the process as straightforward as possible, here’s a look at what you can expect when applying for a loan as a self-employed borrower, potential complications you might encounter, and documents you should have handy when applying. We’ll also look at some things that you can do to get yourself into a position to be a stronger borrower, which means you’ll be able to negotiate better loan terms as well.
Why Do the Banks Look More Closely at W-9 Workers?
Before the mortgage crisis of 2008, borrowers who had a good credit score didn’t need to jump through nearly as many hoops.
In fact, all they needed to do for a SISA loan, was state their income and assets, there weren’t any checks done to verify their income. Unfortunately, though, this resulted in many people exaggerating their income and obtaining mortgages that they couldn’t afford. These days, most banks will require a lot more information and won’t simply take your word for it.
In cases where a bank does do a no-documentation loan, the borrower will need to have a credit score of 700 or higher, make a down payment of 20% or greater, and will face interest rates of up to 5% higher than market rates. For this reason, it’s usually a better option to try to qualify for a conventional loan if you can.
For W-2 employees, applying for a mortgage is relatively easy. This is because these workers have a consistent amount of income each year. This consistency is something that the banks love, and it makes it simple for them to accurately predict an applicant’s future income.
Self-employed borrowers, on the other hand, while they may generate a good income, often have the issue of inconsistency. Income can vary from year to year. Then there’s the unpredictable nature of self-employment, just because things are good one year, doesn’t guarantee they will be the next. This, combined with the low-commitment and lack of an ongoing contractual commitment between self-employed people and their clients means that things can change at any time.
There’s another reason self-employed borrowers may struggle to obtain a mortgage through traditional funding: tax write-offs could reduce their net income –at least on paper.
Self-employed workers are often eligible for a number of tax deductions, but the more tax breaks you take, the lower your income will appear to be to the bank. When they’re checking your debt-to-income ratio, it could be too high. This could mean that you’d have to decrease the loan amount or increase your down payment. Keep in mind that most lenders prefer your debt-to-income ratio to be between 31-43%.
Important Documentation You’ll Need to Provide
When it comes to gaining approval for a mortgage, much of your success will depend on the information you’re able to provide. Here are some things you’ll need to document for the bank.
- Proof of Income
For the self-employed, proof of income is usually a bit more challenging to prove than employment income. Instead of having one source of income, you usually have multiple sources. The good news though, is that being self-employed you’re most likely already keeping track of your income for taxes.
Having a steady income is vital when it comes to getting approved for a mortgage, but it can be difficult to prove this when you are self-employed. Having your previous year’s income tax reports can help prove that you have a consistent income. You might also consider bringing in profit and loss forms. Keep in mind that even if you make consistent money now, your past income will also influence your ability to get a loan.
Your lender will most likely ask for the following:
- Your personal tax returns (including W-2s if you’re paid through your corporation)
- Profit and loss forms
Tip: While it isn’t required, if you are looking to make things easier on yourself down the road, you might consider having your company pay you a W-2 wage instead of an owner’s draw. This will help you be able to prove that you have an income, and a solid one, at that.
- Proof of Employment
Most banks will require you to have uninterrupted self-employment income for at least two years. You might qualify if you have only been in business for a year, if you have had previous experience in that field, and are earning at least as much self-employed as you were before. You may also need to provide your business license, copies of insurance, and any other documents attesting to your compliance with legal requirements for your company.
You may need to show the bank the following documents:
- Letters from current clients
- A letter from your CPA
- Any state or business licenses
- Evidence of insurance
What Lenders Look For
Regardless of your employment status, your lender is going to want to ensure you have the ability to pay back your mortgage.
If you are looking to take out a mortgage in the future, there are some things you should consider now to help make the process easier, and help you to qualify for better loan terms –like a lower interest rate.
- A Solid Credit Score
One of the most important things you can do to help increase your chances of approval is to improve your credit score. A lower credit score means you’ll have lower the chances of getting approved, or if you are approved, you may end up having a higher interest rate. To start improving your credit rating, pull a copy of your credit report from each of the three national credit bureaus –Equifax, Experian, and TransUnion, and review your credit reports. Then get to work building, or improving your credit rating. Things like paying off your credit cards every month and ensuring that you don’t utilize more than 30% of your credit card limits can help you to build your score up.
- A Low Debt-to-Income Ratio
The debt-to-income ratio (DTI) is how much of your gross monthly income goes towards paying your monthly bills. The lower your DTI ratio, the lower risk you present for the bank. To calculate your DTI, determine how much you pay in reoccurring monthly debt obligations and divide it by your monthly income pre-taxes. If your DTI 36% or higher, you might consider working on that before applying for a loan.
- Assets and Reserves
Most lenders will want you to have a certain amount in reserves. This should usually be enough to cover at least six months’ worth of mortgage payments, along with taxes and insurance.
- Find an Investor-Friendly Lender
One of the best things you can do when looking to buy an investment property is to assemble a team of qualified professionals who will be able to help guide you through the process. Finding an investor-friendly lender is crucial when it comes to getting the best loan terms possible, and can help you to navigate the ins and outs of obtaining financing as well.
Consider an FHA Loan
Finally, keep in mind that financing an investment property is different than buying your first property. With your first home, you’ll be eligible for an FHA loan, and potentially, a 3.5% downpayment. For investment properties, the banks generally require a downpayment of 20-25%.
However, there is a way that you can obtain your first investment property using an FHA loan. This strategy is known as “house hacking,” and involves buying a duplex or four-plex and living in one unit while renting the others out, then you would be eligible for an FHA loan.
It’s definitely possible to obtain a loan if you are self-employed; it just takes some extra work. But then again, as a business owner, you already know a thing or two about working hard. Being prepared allows you to take steps early on to get yourself into a strong position to borrow, helping you to secure a loan with the best terms possible.
Are you ready to start adding real estate investments to your portfolio? See: What every first-time investor should know and First-time income property investors, how to begin.
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