The mortgage process is a little bit different when you’re self-employed. It usually involves more documentation, and the qualification process can be more difficult.
That’s why it’s important to know how to qualify for a mortgage when you’re self-employed.
Step-by-step process for qualifying and applying for a mortgage when you’re self-employed
Whether you’re in a salaried job or you’re self-employed, qualifying for a mortgage is a multi-layer process. Here’s how that process works for self-employed borrowers:
Step 1: Income
In most respects, this is the most critical aspect of your financial profile. The lender will be looking to verify the stability of your income, in addition to how much you earn.
To do that, they’ll typically require the following documentation:
- Complete personal income tax returns for the two most recent tax years, complete with all schedules.
- If your business operates as a corporation or a partnership, they’ll also require complete business income tax returns for the past two years.
- If you have not filed your most recent tax return, a profit and loss statement, audited by a CPA, may be required.
- A copy of a business license, or a written statement from a CPA confirming that you have been in business for at least two years.
With this documentation, the lender will most likely average your business income for the past two years. For example, if you earned $80,000 in 2016, $120,000 in 2017, the lender will determine your stable income to be $100,000, or $8,333 per month ($80,000 + $120,000, divided by 24 months).
Income evaluation is the major criteria that makes qualifying for a mortgage as a self-employed borrower more difficult than it is for employed borrowers.
Step 2: Credit
Mortgage lenders typically look for a minimum credit score of 620. And while it’s possible to qualify for a mortgage as a self-employed borrower with a score that low, the likelihood of approval is greater if your score is much higher.
Since income is almost always considered an issue with the self-employed, a strong credit profile can help to offset that risk. A credit score over 700 will be a big advantage.
This is why it’s more important for a self-employed borrower to regularly monitor their credit scores than it is for other borrowers. You need to be prepared to correct any errors on your report, and to make sure you’re maintaining a high score. You can monitor your credit for free through sites/apps like Credit Sesame.
Step 3: Assets and down payment
The down payment is also a more important factor with the self-employed. While salaried borrowers might be able get by with a down payment of three or 5%, lenders typically look for larger down payments from the self-employed. For example, a down payment of 20% will be considered a strong compensating factor to offset income risk.
Step 4: Debt-to-income ratio (DTI)
This is a mortgage industry term that describes the formula used to determine that your income is sufficient for the loan you’re applying for.
There are actually two ratios:
That’s your new monthly house payment, divided by your stable monthly income.
If your stable monthly income is $6,000, in the new house payment will be $1,500, your housing DTI will be 25% ($1,500 divided by $6,000).
Your new monthly housing payment includes the new mortgage payment, plus monthly allocations for property taxes, homeowner’s insurance, private mortgage insurance, flood or earthquake insurance, or homeowner’s association dues. It does not include utility payments.
Total debt DTI
That’s your new house payment, plus non-housing recurring debt, divided by your stable monthly income.
For example, if your stable monthly income a $6,000, and the new house payment is $1,500, but you also have $500 in recurring non-housing debt, your total DTI will be 33% ($2,000 divided by $6,000).
Recurring non-housing debt includes:
- monthly payments for credit cards
- car loans
- student loans
- other loans
- child support or alimony
- payments on other real estate you may own.
It does not include monthly auto, life and health insurance payments, or subscriptions, like a gym membership.
The standard allowable ratios are 28% and 36%, or what you may have heard expressed as the “28/36” rule. To the degree that your ratios are within these guidelines, you’re well qualified for the new mortgage. To the degree that you exceed them, the likelihood of decline increases.
In recent years, 28/36 has been routinely exceeded, usually when you have a large down payment (20% or more), excellent credit (roughly 720 or higher), and adequate cash reserves (equal to six months or more of your new house payment).
DTI complication for the self-employed
Small business owners often have business related debt. Generally speaking, mortgage lenders will include these debts in your total DTI. That could cause your DTI to go higher than the allowable limits.
Here’s the problem…Business owners often have what they consider to be business loans, that are actually personal loans. It could be a car payment, a credit card line, or even an actual business loan. But since you are most likely on that loan personally, it will usually be considered a recurring debt.
The bottom line is that mortgage lenders usually don’t differentiate between business and personal debt.
The best place to find a mortgage if you’re self-employed
There really are no mortgage lenders that specialize in providing loans to self-employed borrowers. The reason is that the mortgage process is incredibly standardized. This is in addition to the fact that most loans are ultimately sold too (or insured by) the same four agencies—Fannie Mae, Freddie Mac, FHA, and VA.
That being the case, what it really comes down to how quickly a lender can process your loan, as well as the additional banking services they can provide. Check out Lending Tree, a major comparison site that matches you with the right lender based on your needs and credit quality.
Or you can check out this list below, which contains what we believe to be the top mortgage lenders in the country.
Why is qualifying for a mortgage more difficult if you’re self-employed?
Your income is more complicated
The primary reason has to do with the way your income is perceived. It’s simply not as easy to verify as it is someone who is employed by a company. As an employee, a recent pay stub and W2 may be all that’s needed to verify income and employment.
Since there is no central income or employer, a self-employed borrower needs to prove both the existence of their business, as well as the income received. And since income can fluctuate from one year to the next, you may also have to prove that both the business and the income are stable.
You’re perceived as being a higher risk
In general, however, mortgage lenders typically consider self-employed borrowers to be higher risk. For that reason, criteria for credit and assets may also be more stringent. The lender may require the self-employed borrower to have a stronger financial profile overall, to offset the additional risk.
Getting a mortgage when you’re self-employed is very doable, but you must be prepared for the extra challenges and documentation requirements you will face.