As of 2014, there are approximately 10 million self-employed people in the United States. If you’re one of them and you’re in the market for a new home, you may face some extra hurdles during your home buying journey. While lenders are used to working with self-employed borrowers, buying a home when you’re self-employed requires extra documentation of your income and finances.
Here are some common questions that many self-employed buyers have asked me.
How can I prove my income to a lender?
In order to prove your income to a lender, you will need to provide at least two years of tax returns, says Tim Lucas, a mortgage loan originator and processor and an editor at My Mortgage Insider. You may also need to provide your lender with a profit-and-loss statement. Because taxes are filed for the previous year, you may have to wait several years until you have enough income documentation.
“It actually almost takes three years to get there since you are filing for the year prior,” Lucas says. It may take even take longer if your business has seen dramatic income shifts from year to year.
There are exceptions, he adds, for those who can show one year of self-employment on their taxes as well as W-2s from a previous employer in the same field. For example, if your employer shifts you from a salaried employee to a 1099 contractor, you may not need to wait three years.
The lender will also want to know your monthly wage. To determine this, take your past two years’ net income (after expenses but before taxes) and add it to the current year’s total income. Divide that amount by the number of months covered by the tax returns to reach a monthly income figure.
Using this formula, you can figure out the size of the loan for which you’re likely to get approved, in the same way salaried employees do. The more income you have, the more house you can buy.
Tip: When you’re buying a home , having some extra cash reserve in a savings account, such as a year’s worth of mortgage payments, may improve your chance of getting approved for a mortgage.
How do I get started with the home buying process?
To begin the process, the first step is to speak to a lender and find out what kind of information that lender will need. It may vary depending on how much of the company you own. If you are a sole proprietor, for example, your personal tax returns will stand as the income. If you own a 25 percent share (or more) of the business, you will need to show your personal tax returns as well as your corporate tax returns.
This information will help the lender determine if “this business going to survive for the next ten years while this mortgage is active,” Lucas says. “They are just looking at the health of the business.”
Self-employed borrowers must complete IRS Form 4506-T, which allows lenders to request tax transcripts. In addition to your tax returns with all schedules, the lender may also require a letter from your certified public accountant (CPA) affirming that you are still running your business as indicated by your tax forms and other documentation.
Tip: Keep your documents as organized as possible. A lender might want to see where certain deposits came from or how you paid for major expenses.
Will a lender look at business deductions?
Small business owners often use tax deductions to save on business expenses, but those deductions lower the income generated by the business. You may pay less in taxes, but your reduced income can also render you ineligible for a mortgage. In this case, on paper, you may appear to a lender that you cannot afford the mortgage, even if you can easily afford the loan payments.
For example, if you buy an $80,000 vehicle for your business but write it off , you won’t pay tax on it, but your overall income will appear $80,000 less than it would be if you paid the tax.
Tip: If you want to qualify for a mortgage, let your CPA know of your plans up front so that you can decide what to write off and what you should pay taxes on.
If I have a great credit score, will I have an easier time getting a mortgage as a self-employed person?
Just as with a W-2 employee, your credit score will be an important factor that lenders will consider when determining whether to give you a mortgage and at what interest rate. An excellent credit score can improve your chances of being approved but an average credit score may not be a disqualifier, Lucas says.
If your credit score is not perfect, you can still be approved for a loan, you’ll just likely pay higher interest rates than other borrowers with better credit scores. A high credit score, on the other hand, can be a compensating factor if your business shows declining revenues from one year to the next on your tax returns.
Tip: If you are able, offer the lender a higher down payment in order to offset a low credit score.
Should I consider a “non-traditional” mortgage?
It may be easier for a self-employed borrower to be approved by a lender that specializes in non-traditional mortgages—but it may also be more costly. “Obviously that interest rate is going to be a lot higher” on specialized loan agreements, Lucas notes.
If your business is new, or if you have poor credit, you may want to consider entering into a seller financing arrangement or working with a hard money lender, a specialized lender that finances loans based on the real estate property value instead of the borrower’s credit history
In a seller financing arrangement, the property owner acts as a lender, extending to you the credit that you pay back over time, just as you would in a traditional mortgage. Typically, the interest rates are higher in this type of arrangement, and you have to make sure that the owner reports your payments to the credit reporting agencies (CRAs).
You may also want to look at financing from a hard money lender, where the value of the property backs the loan instead of the credit of the borrower. Hard money lenders offer short-term loans that rely heavily on the value of the property to determine the lending standards. These loans may be easier to acquire and may be processed more quickly than loans from a traditional lender.
Finally, if a business partner or relative is willing to help you get a loan, you may want to opt for a co-signer agreement. However, remember that any co-signer needs to have an excellent credit history.
It’s not impossible to get a loan if you are self-employed, but be ready to work closely with a lender and a CPA, and, if necessary, wait until you’ve built up your business and your credit score.