There are many advantages to being self-employed: you can set your own hours, decide how you want to do your work, and determine the type of work you want to take on.  But self-employment presents its own unique challenges as well. One of those challenges surfaces when you decide to apply for a mortgage.

Applying for a mortgage is a big deal regardless of whether or not you are self-employed.  But it you are, there’s more work for you to do, and you are held to a higher standard than you would be if you were a W-2 employee. This is because lenders consider loans to self-employed individuals to be more risky, due to their lack of a dependable and stable income stream.  Contrary to this generalization, many self-employed people have a very stable and dependable income, but it is up to you to prove it to your lender.

WHAT LENDERS WANT

The first step in maximizing your chances of being approved for a mortgage is to understand what mortgage lenders are looking for in a borrower.  In this article, we will cover the following three major financial categories evaluated by lenders when they consider you for a mortgage:

  1. Income and Debt
  2. Credit history
  3. Cash reserves

1)  INCOME AND DEBT

Income

In order to demonstrate to your mortgage lender that you are worthy of a loan, you need to prove to them that you will be able to pay back the loan over a long period of time.  Proving adequate income is easy for W-2 employees; they have to present their W-2 and the lender knows exactly how much they should be making each month. A steady paycheck gives lenders confidence that the loan will be repaid.

The biggest challenge for self-employed individuals is proving income, this usually requires you to show two years of self-employment income.  Lenders like to see income that is consistent or increasing annually, and a longer history of self-employment income is better, because lenders like stability.  When calculating your self-employment income, be aware that lenders don’t consider your gross income, they consider your income after deductions.  This is important to mention because many self-employed individuals and business owners claim substantial business tax deductions to minimize their tax burden.  But remember, while big deductions decrease your taxes, they also decrease the income you can report.

What if you don’t have two years of self employment income to show?  This doesn’t mean that you will automatically be denied a mortgage. If you are now self-employed but you have previously worked as a W-2 employee in the same field, lenders will often make an exception to the requirement for two years of income.  Lenders want to see consistency, so if you have been working consistently in the same field and making a stable income, this will increase your chances of being approved.  

Debt to Income Ratio

Another measure used by lenders to determine your ability to repay a mortgage is your debt-to-income ratio.  Your debt-to-income ratio (aka DTI ratio) is calculated by dividing your monthly debt payments by your monthly income.  It is a measurement if how much money you have coming in compared to how much money you have going out toward your debt payments.

Example: Your monthly income is $8,000 and you have $2,000 of payments on your debts due each month.  2000 ÷ 8000 = 0.25 so your debt-to-income ratio in this example is 25%.

Lenders like to see a low debt-to-income ratio.  The cutoff for a mortgage is generally a DTI ratio of 43%, any higher than that and you are unlikely to get approved.  The goal should be to keep your ratio below 36% to have the best chance of being approved. The lower the better.

If you currently don’t have an acceptable debt-to-income ratio, you obviously need to either increase your income, minimize your debts, or both.  

  • Minimizing Debt: Prior to applying for a mortgage try to pay off as much of your debt as you can so that you can get your ratio on track.  Definitely minimize or eliminate high interest revolving debt like credit card debt, lenders don’t look favorably on large amounts of credit card debt.    
  • Maximizing Income:  As mentioned earlier, many self-employed individuals take extensive tax deductions for business expenses which reduce the income portion of your DTI ratio.  Talk you your accountant to see if it makes sense for you to reduce your deductions to achieve an acceptable DTI ratio.

2)  CREDIT HISTORY

Not surprisingly, another important factor considered by lenders is your credit history.  Your credit score / credit report will be a factor in determining if you are worthy of a loan.  It will also have a significant impact on the interest rate you get on your mortgage, so make sure your credit report is accurate and in tip-top form.  

You can get a free credit report once a year from each of the three main credit bureaus (Experian, Equifax, and Transunion).  You can request these credit reports at annualcreditreport.com. If you are going to be applying for a mortgage soon, it is a good idea to get these credit reports and check them to make sure they don’t contain any errors or misinformation.  If you find an error you can file a dispute with the credit bureau or, better yet, with the specific creditor associated with the error.

To keep track of your credit score, you can sign up for a free service like Credit Karma or Credit Sesame.  While the credit score you get from these services is not your official FICO score, they give you a good idea of where you stand and will alert to you any significant changes in your credit score.  Using these services will also show you areas in which your credit history is weak, and give you ideas about how you can improve your credit score.

A good credit history and a strong credit score will show your lender that you have a history of managing your credit responsibly, and making your payments on time.  These are exactly the qualities that give a lender confidence that you will pay back your loan on time.

3)  CASH RESERVES

Because your income can be variable when you are self employed, it can be hard to make regular mortgage payments in times when your income decreases.  For this reason, lenders want to see that you have significant money saved, to act as a cushion allowing you to make your mortgage payments even if you have less income for a period of time.

We all know that it’s hard enough to save up a 20% down payment for a house, but to have your best chance of getting approved for a mortgage, you need to have money saved in excess of your down payment.  The lender does not want to see that you have exactly enough cash on hand to just be able to pay the down payment.  Your cash reserves need to be above and beyond the money you have saved for the down payment.

WHAT IF YOUR MORTGAGE APPLICATION IS DECLINED?

If you are not initially successful in getting approved for your mortgage, there are actions you can take to increase your chances when you apply again.

  1. Consider applying for a smaller mortgage.  If you are not asking to borrow as much money, your lender’s income requirements won’t be as strict.
  2. Save a larger down payment.  Although it will take some time to save a bigger down payment, this will make getting approved easier because the bigger your down payment is, the less risk there is for the lender.
  3. Work on paying off debt.  This will have a double-positive effect by improving your DTI ratio and also decreasing your credit utilization ratio, which will increase your credit score.
  4. Consider a cosigner.  If you are having difficulty getting approved on your own, one option is to have someone you know cosign the mortgage.  By cosigning, they agree to be on the hook for your mortgage payments if you don’t pay. Having a cosigner will make it easier to get approved for the mortgage, but it is a risky move for the cosigner to make.

USEFUL TIPS

  • Hire a mortgage broker.  Since getting a mortgage is more involved when you are self-employed.  Having a professional to help you navigate the process can be very helpful.
  • Use an accountant to prepare the financial documentation you need to present to your lender.  This will minimize the chance of errors, or omitting important information.
  • Keep business and personal finances separate.  Having a separate business checking account and credit card will make preparation of your financial documentation easier and will eliminate any confusion.

While there are more hoops to jump through, getting a mortgage is totally possible if you are self-employed.  You just need to pay a little more attention to your finances and record keeping than you would if you were a W-2 employee.         

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