Why is it so hard for the self-employed workers to get a mortgage?

By Housing Nonprofit

The homebuying process will be harder if you’re self-employed rather than being a salaried employee. Here is how to get ready for home ownership if you’re self employed.

  • Maintain separate records for business and personal finances
  • Providing additional documentation to verify income and debt
  • Minimizing tax deductions

Is it possible for self-employed individuals to qualify for a mortgage?

Self-employed, gig workers, freelancers, and an independent contractor sometimes have non-regular income. Without a regular paycheck or W-2 statement, it can be difficult to provide evidence of consistent income. Without concrete proof of consistent income, lenders will ask for more cash up front and charge higher interest rates.

The key is having verified income and manageable debt. Having that, self employed and contract workers have a real chance at getting approved for a home loan.

How can you determine if you classify as a self-employed individual?

Individuals who hold a 25 percent or greater share in a business or partnership are categorized as self-employed when applying for a mortgage. Even if you have a second job with salaried income, lenders will scrutinize your self-employment income for any vulnerability.

What are the steps involved in obtaining a mortgage as a self-employed individual?

The loan process for self-employed individuals is similar to that of others. It involves obtaining a rate quote, completing an application, signing paperwork, and providing documentation. The down payment, debt-to-income ratio, and credit requirements also remain the same for both. The difference lies in the documentation. While employed applicants provide W-2 forms as proof of income, self-employed borrowers are required to provide their 1040 tax returns, including all schedules, as evidence of income. That’s where the challenge arises. Since self-employed individuals often deduct various expenses that are not available to W-2 employees, it results in a significantly lower net income after write-offs. This lower net income can make it more difficult to meet the requirements for a mortgage, particularly the debt-to-income ratio.

β€œIt is crucial to demonstrate a net income, after write-offs, that meets the preferred debt-to-income ratio set by lenders which ranges from 36% to 43%.”

What are the requirements to qualify for a mortgage as a self-employed individual?

The primary requirement is to have a minimum of two years of business history before applying for a mortgage. However, there are certain cases, where some new mortgages may be considered as early as one year. This is applicable when a substantial down payment is made and only a small mortgage amount is required. In such scenarios, the financial risk to the bank is lower compared to individuals with minimal down payment and higher loan amounts. If you lack a large down payment, it is advisable to wait for at least two years before applying for a mortgage. This waiting period demonstrates consistent income and the success of the business. The chances of securing a mortgage improve with a larger down payment and a longer track record of the business being in operation.

How can you improve your chances of getting a mortgage when self-employed?

You can increase your chances of being approved for a home mortgage by doing the following:

  • Register and license your business
  • Pay yourself a W-2 wage instead of an owner’s withdrawal
  • Reduce your debt
  • Improve your credit score for receiving a lower interest rate
  • Minimize your tax deductions
  • Lower your debt-to-income ratio
  • Maintain separate business and personal accounts
  • Shop around for a business friendly lender
  • Keep thorough records using tools like QuickBooks
  • Consider making a larger down payment, possibly using funds from your IRA or 401(k)
  • Explore working with a local credit union or mortgage company that values relationships

What are the documents required to qualify for a mortgage?

There are two categories of documents required: employment verification and income verification.

The documents required for employment verification are: copy of business license, proof of business insurance (if applicable), Articles of incorporation, LLC or partnership (if applicable), state or federal permits along with any other employment-related documentation that may be required by a lender to confirm your employment.

The documents required for income verification are: at least two years of both your federal business and personal income tax returns, proof of your assets and liability, recent business bank statements and income statements, an itemized list of unpaid accounts receivable along with any other income-related documentation that may be required by a lender to confirm your income.

What to do if you don’t qualify for a mortgage?

If you are unable to secure approval for a conventional mortgage, you have the option to apply for a non-conforming loan such as a non-qualifying mortgage loan (non-QM mortgage). These loans have alternative criteria for qualification and may consider factors beyond traditional income and credit requirements. They are offered to borrowers who may not meet the strict guidelines of qualified mortgages but still have the ability to repay the loan based on other factors such as assets, bank statements, or unique income sources. It is important to note that non-conforming loans may have higher interest rates, closing costs, and less favorable repayment terms. Alternatively, you may consider applying for a personal loan, although the maximum amount you can borrow may not cover the entire cost of the home purchase.

In the case of a refinance denial, you could explore the possibility of applying for a home equity loan or a home equity line of credit (HELOC) if you have accumulated sufficient equity in your property and meet the eligibility criteria.