If you are self-employed and are thinking about applying for a mortgage, you have likely heard mortgage financing war stories from other self-employed colleagues that speak to a process that asks for an endless stream of paperwork.
And while self-employed borrowers tend to need more paperwork (than their salaried employee counterparts) to verify their income and employment, the reality is that if you know what to expect when applying for a mortgage as a self-employed borrower, the paperwork can be easily managed.
The narrative that follows provides insight into the documentation that will be required to verify the income and employment of a self-employed mortgage applicant.
Basic Underwriting Principles
Mortgage applicants – whether they are self-employed or employees of another firm – are evaluated based on three primary underwriting principles. Underwriting computer systems – and human underwriters, are tasked with determining the answers to these questions as they grapple with a final underwriting mortgage decision.
- Principle # 1 – What is the mortgage loan’s collateral?
Before the final underwriting decision can be made, the credit decision-maker reviews the subject property’s appraisal, which is typically required to be done by a certified or licensed real estate appraiser. The appraiser provides value and offers insight into the property’s location, size, condition, and other relevant property data.
- Principle # 2 – Will the mortgage applicant pay the mortgage according to the agreed upon terms?
A borrower’s credit report offers tremendous information about an individual’s ability to manage credit judiciously, make timely payments, and avoid financial missteps like a judgment, foreclosure, repossession, or charge-off. This underwriting principle reflects a matter of intention and willingness.
Self-employed mortgage applicants will find there is little to no additional paperwork regarding their credit history because of their status as business owners.
- Principle # 3 – Can the mortgage applicant pay the mortgage according to the agreed upon terms?
This underwriting principle refers to a borrower’s ability to pay – in other words, how stable is the borrower’s work history?
An underwriter needs to analyze a borrower’s income to make a sound underwriting decision. Self-employed borrowers may be mandated to provide more than a W2 or pay stub to verify the borrower’s income and work history.
Securing a Mortgage as a Self-Employed Borrower
Asset Documentation for the Self-employed Borrower
Lenders require mortgage applicants to verify the source of their down payment (for a purchase transaction) and the funds required to close – for both purchases and refinances.
Are these funds from a loan? A gift?
Assets can easily be verified by the provision of bank statements, or asset statements from the borrower.
How Many Years Must a Borrower be Self-Employed to Qualify for a Mortgage?
Certain self-employed mortgage applicants do not have to show 2 years of self-employment work history to qualify for a mortgage loan.
Per Fannie Mae guidelines, a borrower can verify that they are self-employed for a minimum of 12 months if they can meet both of these conditions:
- Verify that they have prior professional experience in the same field as their self-employed business, and
- Verify that they have earned as much as an employee in that field before becoming self-employed in that field.
Income and Employment Documentation for the Self-Employed Borrower
Self-employed borrowers present unique underwriting dilemmas for lenders. Business owners smartly take advantage of the financial and tax benefits offered to business owners – through impressive write-offs that lower the business’s bottom line. However, reducing one’s income by increasing business expenses tends to lower your taxable income.
Yet, most underwriting guidelines advise that income must be stable and ongoing if it is going to be used to qualify a mortgage applicant.
The Taxable Income Challenge
Lenders can only use the taxable income to qualify a borrower for mortgage approval. This is an important issue for self-employed borrowers because business owners write off every legitimate business expense to minimize the self-employment tax levied and standard income taxes.
But fear not, lenders understand this dilemma and have given underwriters a somewhat complex formula to use when qualifying a self-employed mortgage applicant who meets self-employment underwriting criteria.
While each lender chooses their own underwriting criteria, most lenders begin analyzing the income from self-employed individuals by adding-back certain non-cash expenses, like depreciation.
If your business tends to have long cycles of growth and contraction, be certain to give the lender several years of tax returns and a written explanation regarding the specific cycles of the situation and industry. Any significant changes to income from year to year – must be explained in detail and provided to the lender or lender’s underwriter.
Since the mid 2015s, Fannie Mae loosened its underwriting guidelines for those borrowers who are self-employed. These underwriting policy updates include three fundamental areas:
- Self-employed borrowers who only take checks sporadically or through erratic business distributions.
- Self-employed borrowers who cannot provide two years of federal tax returns to verify their business and income.
- Employees who receive a salary, but have self-employment income from a part-time job do not need to verify the part-time income if it is not needed to qualify for the mortgage.
However, since the coronavirus hit, and the economy has hit the skids, Fannie Mae and Freddie Mac have decided to raise the lending bar for self-employed borrowers. The objective of these tightened guidelines is to ensure a self-employed borrower’s business status has not hit the skids since the coronavirus hit the US in January 2020.
Verifying Self-Employment Income
- The revised guidelines for self-employed borrowers no longer require a self-employed mortgage applicant to verify they have access to the business income, as long as they can document that they have an established pattern or history of paying themselves regularly.
- Self-employed borrowers must still show that their business generates income that is sufficient to support the mortgage loan requested. Additionally, borrowers must evidence that regular distributions to the borrower from the business will not impact the business’ viability and profitability.
- Self-employed borrowers may qualify for a mortgage with the provision of just one year of federal tax returns. These federal 1040s must document that the borrower(s) have earned at least twelve months of business income from this self-employment source.
- It is noted that a self-employed mortgage applicant must meet the lender’s backend debt (DTI) ratio requirements. This ratio typically requires that a borrower’s monthly nut (that is, their total monthly obligation for all debt) remain 43%, or below. Note though, for supremely qualified mortgage applicants, the DTI can go as high as 50%.
- Self-employed borrowers do not need to verify their self-employed income if the self-employed income will not be used in the qualification of the borrower for the mortgage requested.
- Co-borrowers who are self-employed- but are not needed to qualify for the mortgage – do not have to provide documentation.
Remember – to increase one’s chances of being approved for the mortgage you desire; it is best to provide at least one year of tax returns (for the prior year) and a current financial statement.
Documentation for the Self-employed Borrower
To play it safe, if you are self-employed and are ready to apply for a mortgage begin to gather these documents that you may need to submit to a lender:
- 2 years of personal federal tax returns (1040s).
- 2 years of business tax returns (1120s, or K-1, etc.).
- Your business license, if applicable.
- A current balance sheet for the business.
- A Year-to-date Profit & Loss statement for the business.
- A letter from your accountant indicating the business is viable and operational.
It is noted that accounting professionals often receive these sorts of requests and often can provide them to you in about a day or so.
Mortgage Options for the Self-Employed Borrower With Reduced Taxable Income
Since the mortgage meltdown of 2008-2009, self-employed individuals have found it challenging to obtain a mortgage. This is because self-employed borrower loans performed poorly during this real estate downturn.
However, lenders have begun to recognize a very large unmet need in the mortgage market and have since begun to offer mortgage loans to those self-employed borrowers who meet the lender’s underwriting criteria.
Here are a few options for self-employed borrowers.
Bank Statement Mortgage Loan Programs
Mortgage applicants who are self-employed and choose to write-off business expenses that reduce their taxable income can opt for an alternative mortgage product that is based on the documented cash flow through your business.
This type of mortgage loan requires the provision of a minimum of 2 years of bank statements – business and personal – all pages. The lender’s underwriter will average the amount of cash moving through these accounts and use this averaged income to qualify you for the mortgage requested.
It Helps to Have a Coborrower Who is Salaried
To improve your chances of receiving a mortgage approval, mortgage, it helps to have a co-borrower (a spouse, a parent, a relative, or trusted friend) who can provide a stable work history with the provision of a W2 or paystub.
Improving Your Chances of a Mortgage Approval as a Self-Employed Borrower
There are sound, proven ways to increase the odds of obtaining a mortgage loan approval as a self-employed borrower. They are detailed below.
Check Your Credit and Take Steps to Improve Your Credit Score
In modern American, it is essential to keep an eye on your credit score because, in most borrowing situations, the higher one’s credit score, the more attractive the borrower’s prospects become. If you have not yet requested your credit report (one free copy per year is allowed from each repository), now is the time to make sure your credit report has not erroneous information that may damage your chances of approval in the future.
For Purchases, Max out Your Down Payment
The sound logic behind this advice is that a borrower with higher amounts of equity in their home will be less likely to walk away from the house/mortgage, should the borrower(s) find themselves in financial hot water.
The More Assets, The Better
Lenders are simply more comfortable when a borrower closes on a mortgage with tremendous reserves for emergencies. These funds can be liquid or non-liquid, i.e., stocks/bonds/gold.
Pay Down/Eliminate Consumer Debt
Eliminating debt frees up income that helps you qualify for a larger mortgage amount. This includes car loans, credit cards, and personal loans, among others.
Get Prequalified To Ensure the Mortgage Process Goes As Planned
If you are ready to submit a mortgage application as you consider buying a home, it pays to obtain a mortgage prequalification. By getting pre-qualified, you can make an offer to purchase that can be backed up by a lender-issued prequal letter.
- A self-employed borrower will likely have to submit more paperwork than a borrower who is a salaried employee, although, it is noted that this is not as bad as most believe.
- Lenders qualify self-employed borrowers based on their taxable income – which must include ongoing, stable, and consistent distributions. This can create a challenge for self-employed borrowers whose business expenses reduce their taxable income to a level that doesn’t support the mortgage loan.
Self-employed borrowers can increase their chances of being approved for a mortgage by –
- Taking steps to increase their credit score.
- Coming in with a large down payment when purchasing a home.
- Eliminating or paying down consumer down debt.
- Choosing to make an offer to purchase with an attached prequalification letter from your lender.