Self-Employed Mortgage: Understanding The Basics

A self-employed borrower can apply for the same mortgages as a W-2 employee.  Whether it is a conventional or government-backed loan like FHA or VA—the type of loan a borrower receives is the same regardless of their income source. But the foremost challenge for the self-employed borrower is proving their income. Read on to learn how business owners can prepare and be successful when applying for a mortgage.

Proof of Income for the Self-Employed

What is self-employment income? It is profits and losses from a business the borrower has 25% or more ownership. The borrower can be a sole-proprietor or independent contractor with a few or several clients. Or the borrower can have or be part of a partnership, LLC, or corporation.

To count the income, the borrower has to be self-employed for at least two years. One year of self-employment income may be considered if the borrower is in the same line of work.

Here is an example: Joe has been a plumber for six years. One year ago, he started his own plumbing business. There were no gaps in employment, and his income is stable and increasing. He is making more now than he did as an employee. Joe keeps excellent financial records, his credit score is 700, and he has very little debt. Because of this—Joe has a good chance of getting a mortgage.  

What does the underwriter look for?

When looking at a loan application, one of the main things the underwriter does is examine the borrowers' income and financial documentation. The underwriter needs to confirm the income is stable and likely to continue. In addition, they will make sure the income is not declining.

The primary way the underwriter verifies self-employed income is with tax returns—both personal and business. When calculating the income, some tax deductions can be added back. For example, depreciation or depletion. Loan officers, processors, and underwriters can use income worksheets to calculate self-employment income accurately. Depending on the size and complexity of the business, calculating income can be very involved. That is where the income worksheets come in.

How to Calculate Self-Employed Income for a Mortgage

Borrowers that receive a regular paycheck and W2, have an easier time with documentation. They will still need to supply their taxes but having a salary and W2 is a great way to document stable ongoing income.

With co-borrowers, sometimes one borrower is self-employed, and the other one has a regular job. The income from the W2 employed borrower can also be used and, in many cases, make the difference in getting approved.

What income cannot be counted?

Take a look at this list of income that cannot be counted:

1. Income that cannot be verified

Here is an example. A business owner receives cash payments but does not count that income on their taxes. That income cannot be used.

Another problem is when business and personal bank accounts get mixed up. For example, if some business income gets deposited into the personal checking account and others into the business, and some checks are cashed instead of deposited—keeping track of funds becomes a problem. Besides looking at taxes, bank statements are also reviewed. The financial documentation must make sense when comparing with the application.

That is why it is vitally important to have business and personal funds separate. Business expenses and deposits should only go into the business account. Personal expenses and deposits should only go into the personal account.

2. Unstable income 

The underwriter is looking for a stable income and cannot count income that fluctuates. An example could be the sale of an asset like real estate or equipment. If it is a one-time sale, that would not be calculated. Another example could be self-employed income from a sales job where there are huge swings in income and gaps with no income. That would not be counted because it is not stable.  

But keep in mind, seasonal income is different from unstable income. For example, if you have a house painting business and make the majority of your income six months out of the year, that income can be counted. That is, as long as the business is at least two years old, the income can be documented, and is likely to continue.

Private Mortgage Lenders for the Self-Employed

Besides conventional or government-backed home loans, there are private mortgage lenders for the self-employed. They have loan programs that have alternative ways to prove income. For example, some loans use bank statements rather than tax returns. These types of loans have high interest rates and often come with pre-payment penalties. There is no comparison between that type of self-employed loan to conventional or government-backed mortgages with attractive rates.

Rather than take out a high-cost loan, many borrowers choose to work on their income documentation so they can qualify for a conventional or government-backed mortgage.

Credit unions, banks, and mortgage brokers can be good lenders for self-employed borrowers as long as they know how to work with business owners. That includes knowing how to read tax returns and use income worksheets if needed.

Self-Employed Mortgage Requirements

Getting a mortgage when self-employed also requires more documentation than for W2 employed.

Here are the primary documents needed for a self-employed mortgage:

• Business taxes for the last two years, signed and dated with all applicable schedules
• Personal taxes for the last two years, signed and dated with all applicable schedules
• Year-to-date profit and loss and balance sheet 
• Business license
• S corporations will need a business credit report
• Business bank statements, from the most recent two months
• Personal bank statements, from the most recent two months
• Evidence there is enough cash to close from personal, not business funds

Besides verifying income, the borrowers will still need good credit and a score of 620 and above. And just like any other type of loan, they will need an acceptable debt-to-income (DTI) ratio of 43% or lower. Debts include mortgages, credit cards, auto loans, child support, etc.

Here is an example of the DTI calculation:

• Monthly debts = $4,000
• Divided by monthly income = $10,000
• DTI ratio = 40%

Main Takeaway for Self-Employed Borrowers

Self-employed borrowers have more challenges than a wage earner. But, with careful planning, getting the financing to buy or refinance a home is possible.

Savvy borrowers have all of their documents together before they apply and they keep everything close at hand in case anything is needed again. Showing proof of income can be a challenge, but it is worth it in the end.