A lot of Dough Roller readers are self-employed. I know this from talking to countless folks since 2007 when I launched this site. And I’m about to join their ranks. More about that later. But as a personal finance blogger, one of the first things I thought about was my mortgage.
Seriously. Will I be able to refinance my mortgage when I’m self-employed? Should I get a home equity line of credit now just in case? And if my wife and I want to move some day, how easy will it be to qualify for a home loan?
So I spoke to a realtor who has been in the business for 40 years. I also did a ton of research. And the long and short of it is this–while the standards to qualify for a mortgage are no different whether you are a W-2 employee or run your own business, the paperwork and proof of income required are significantly more onerous for business owners.
And there’s another problem. When you apply for a mortgage, you want to show as much income as possible. When you file your tax returns, however, you want to show as little income as possible. Those that are self-employed can deduct expenses that an employee cannot. Great at tax time; not so great when talking to Mr. Mortgage Guy.
So if you are self-employed and thinking of applying for a mortgage, refinance, or home equity line of credit, here are some tips I learned from the best realtor I know and my own research.
Are You Self-Employed?
Sounds like a silly question. Certainly you know whether you are self-employed. But it turns out to be a bit more nuanced than you might have guessed. According to the Loan Prospector Documentation Matrix published by Freddie Mac, a borrower who owns 25% or more of a business is considered self-employed. (If you are having trouble sleeping, you can read the Matrix in pdf format here.)
And even if you don’t plan on using your self-employed income to qualify for a mortgage, you’re not completely out of the woods. Your banker is required to review your personal income tax returns to determine if the business incurs losses that could affect your ability to make your mortgage payments.
Assuming you are self-employed and want to use your self-employed income to qualify for the loan, here’s what you’ll need:
- Document a 2-year history of self-employment to ensure that income is stable.
- If you don’t have a 2-year history in your business, you must document (are you ready for this) “the acceptance of the company’s service or products in the marketplace and document a 2-year history of receipt of income at the same or greater level in the same or similar occupation.”
- The borrower’s tax returns must reflect at least one year of self-employed income.
- The borrow must be able to verify the existence of his or her business. An accountant or attorney is often used for this purpose.
The documentation you’ll need to establish your income depends on whether the loan is streamlined or standard. Here are the requirements for Standard Documentation:
- Individual federal tax returns for the most recent 2 years. The individual federal tax return must reflect at least 12 months of self-employed income.
- Verification of existence of the business through a third party source obtained either no more than 30 Calendar Days prior to the Note Date or after the Note Date but prior to the Delivery Date
Under Streamlined Documentation, you only need the most recent tax return.
You’ll need cash at closing. There are prepaids (taxes and insurance), closing costs, and the down payment. On top of that, every mortgage I’ve ever obtained required me to demonstrate that I had cash reserves equal to three times my mortgage payment. These requirements are no different if you are self-employed. But there is a catch if you are using any of your business’s assets to pay these expenses.
If you use business assets, the bank or mortgage broker must assess how the use of these assets will affect your self-employed income. You may actually have to prepare a cash flow analysis using either personal or business tax returns.
The self-employed can have both personal and business debts. It’s important to keep the separate. Business debts are not included in a self-employed borrower’s debt-to-income ratio. If you don’t keep your business debts separate, however, they could end up being included in the debt-to-income ratio calculation. The result could disqualify you for the best interest rates or even for any mortgage at all.
Good credit is the backbone for borrowing at the best mortgage rates. For details, check out our article on how your credit score affects the interest rate you’ll get on a mortgage. The fact is it can make a huge difference. But when it comes to the self-employed, the credit score requirements are no different than for employees. That’s good news in so far as the requirements aren’t more strict. But if you were hoping that a good credit score would make up for shaky income, think again.
In a sense, there’s really no special “rules” for the self-employed. Rather, the onus is on you to prove the long-term viability of your income streams. Successful self-employed borrowers are always proactive in thinking from the lender’s perspective. As such, they save themselves money, and get the best deal possible given their income and the health of their business.
If you’ve obtained or refinanced a mortgage with self-employed income, please share your experience in the comments below.