Getting a mortgage might be harder for self-employed people, but borrowers around the country do it every day. The self-employed borrower needs not only to provide tax returns but to confirm them with Form 4506-T. This makes the process of qualifying for a mortgage loan run up against the usual strategy of minimizing income for tax purposes. With planning, though, you can live the American dream of owning a house and being your own boss.
How They're the Same
Self-employed borrowers can apply for the same mortgage programs as anyone else. Common loans programs such as conventional loans and FHA loans (including FHA streamline loans) are available to the self-employed, and in traditional terms such as the 15-year or 30-year loan.
Whichever mortgage you choose as a self-employed person, the lender is going to use the same general mortgage underwriting procedure to decide whether or not to lend to you. Underwriting relies on three primary factors – your capacity to repay, your credit history, and the strength of your collateral.
- Capacity To Repay. To calculate your capacity to repay, lenders look at the relationship between your income and your debts. Your front-end debt-to-income (DTI) ratio comes from dividing your proposed mortgage payment into monthly income, while your back-end DTI comes from dividing all of your monthly payments into your monthly income. When you're self-employed, the income is usually based on an average of your preceding two years of income as reported on your tax returns. In addition, the lender will also look at your bank accounts to determine what reserves, if any, you have.
- Credit History. Mortgage lenders look at your credit score just like with any other type of borrower. If you have a good history of managing credit and paying back loans, you are more likely to be approved.
- Collateral. Your lender will also pay careful attention to the value of the property that you are pledging as collateral. Generally, the underwriter will order an appraisal to ensure that its value supports the loan that you are seeking.
How They're Different
They key difference with a self-employed mortgage comes from how your income is analyzed. With a typical mortgage, the lender will usually look at two months of pay stubs to determine the applicant's income. Those pay stubs show the worker's gross income before taking out any deductions.
When you're self-employed, lenders don't have W-2s to use. Instead, they look at your last two year's tax returns. They don't look at your business' top-line income. To get a self-employed mortgage, your debt-to-income ratio gets calculated on your business' bottom line – its profit after expenses.
If you're like most self-employed people, you maximize your business expenses and other deductions. Within the law, you might write off a portion of your home's operating costs, mileage for your car, and even the business portion of personal trips. Some or all of your cell phone bill probably is deductible, too. All of this leaves you with a lower taxable income than you'd have if you were a salaried employee. Unfortunately, lenders don't take this into account. They usually judge you based on your bottom-line income.
Getting a Mortgage While Self-Employed
Self-employment isn't an insurmountable barrier, however. There are a few strategies that you can use to help you qualify for a mortgage loan:
- Buy a house that you can afford taking into account the lower income that the lender will calculate.
- Put more money down to reduce mortgage and PMI payments.
- Ask your financial adviser about taking fewer deductions or other strategies to increase your income. You pay more taxes, but your income may be closer to one that enables you to get your mortgage.