Do Mortgage Lenders Use Gross or Net Income for Self-Employed?

As a self-employed individual, you’ve likely experienced the challenge of securing a mortgage and you’re also probably unsure how your income is classified.

You may find yourself wondering if lenders will consider your gross or net income when evaluating your mortgage application. 

The terms "gross income" and "net income" can be confusing, as these figures can look very different on paper, affecting how much you can borrow and what loan options are available. 

In this guide, we’ll explain the difference between gross and net income, how mortgage lenders use these figures to assess your eligibility, and what you can do to improve your chances of approval. 

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Key Takeaways 

Most lenders prefer net income as it reflects your actual earnings after business expenses, giving a clearer picture of your ability to repay the loan.

Self-employed borrowers need to provide two years of tax returns, bank statements, and profit and loss statements to verify income.

To improve your chances, focus on managing your debt-to-income ratio (DTI), improving your credit score, and considering a larger down payment.

Bank statement loans and conventional loans are common mortgage options for self-employed individuals, each with its own requirements and benefits.

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What is Considered Self-Employment Income for Mortgage Purposes?

When applying for a self-employed mortgage, self-employment income refers to the earnings you make from your own business or freelance work. This can include income from various sources, such as:

• Freelancing or contract work (e.g., graphic designers, writers, consultants)
• Business ownership (e.g., owners of sole proprietorships, partnerships, or LLCs)
• Rental income from properties you own
• Independent contractors or gig economy workers

Lenders consider self-employed income differently from salaried income because it can fluctuate, and it’s more complex to verify. To make sure you're financially stable to handle a mortgage, lenders will typically ask for several documents, such as:

• Tax Returns: Most lenders require at least two years of personal tax returns, including W-2s (if applicable) and any business-related documents like profit and loss statements or business tax returns.
• Bank Statements: These help lenders track the flow of money into and out of your business account.
• Profit and Loss Statements: These show how much money your business makes, including expenses. 

Accurate reporting of your income is essential, not only for approval but for making sure you pay the right amount of taxes. Incorrect or incomplete income reporting can lead to complications in both the mortgage process and your tax filings. 

How is Self-Employment Income Calculated for a Mortgage?

When lenders calculate self-employment income for a mortgage, they follow a specific process to determine your average monthly earnings. 

Here’s how they typically do it:

1. Total Income Calculation

Lenders add up your total income from the last two years, as reported on your tax returns and business records. This includes all income sources like gross revenue, freelance earnings, and rental income.

2. Average Monthly Income

After adding up your total income, lenders divide it by 24 (the number of months in two years) to determine your average monthly income. This helps smooth out any month-to-month fluctuations in your earnings and gives lenders a better idea of your typical income over time.

For example

If your total income for the past two years is $120,000, dividing by 24 months gives you an average monthly income of $5,000.

In addition to calculating your income, lenders also consider your debt-to-income ratio (DTI). The DTI compares your monthly income to your monthly debt payments (like credit cards, car loans, and existing mortgages). A lower DTI is more favourable, as it shows that you have room in your budget to manage a new mortgage.

Mortgage Lender’s Income Considerations

One of the key questions you may have is whether lenders use your gross income or net income. Most lenders typically favour net income for a few important reasons.

Why Most Lenders Favor Net Income

Net income is the amount you take home after all your business expenses have been deducted. Since this is the actual income that is available to cover your personal living expenses and mortgage payments, lenders see it as a more accurate representation of your ability to repay the loan. 

Gross income, on the other hand, includes the total earnings before expenses, which can be misleading when assessing your financial situation.

Impact of High Business Expenses

Self-employed individuals often have significant business expenses (like office supplies, travel costs, and employee wages) that can reduce their net income. 

While this can lower your borrowing capacity, it’s important to remember that these expenses are legitimate and can be deducted when calculating your net income. 

Consideration of Both Income Types

Lenders typically take both gross income and net income into account during the evaluation process. While they primarily rely on net income, they may also look at your gross income as a way to get a clearer picture of your overall earnings. 

Calculation of Net Business Income for Mortgage Applications

When applying for a mortgage as a self-employed borrower, lenders calculate your net business income by deducting business expenses from your total income.

This helps them determine your actual income available for mortgage payments.

Here’s how the process works:

Deducting Business Expenses

Lenders will subtract allowable business expenses from your total business income to calculate your net income. These expenses can include anything necessary to run your business, such as:

Depreciation and Amortization
Depreciation refers to the reduction in value of long-term assets (like equipment or property) over time.

Amortization is the process of spreading out the cost of intangible assets (like patents or software) over several years.

Both depreciation and amortization are non-cash deductions, which means they reduce your taxable income but don’t impact your actual cash flow.

Mortgage Options for Self-Employed Individuals

As a self-employed borrower, finding the right mortgage option can be a bit more complex than for salaried individuals. 

However, there are mortgage products specifically designed to help self-employed individuals. Two common options are bank statement loans and conventional loans. 

Bank Statement Loans

Bank statement loans are a popular option for self-employed individuals who may have difficulty providing traditional income documentation, such as tax returns or W-2s. Instead, these loans are based on the income reflected in your bank statements, typically from the last 12 to 24 months.

Lenders will look at your monthly deposits and assess the consistency of your income. They focus on how much money is coming into your business account each month, rather than your net or gross income as reported on tax returns.

This option can be beneficial for self-employed individuals who have good cash flow but may not have a consistent salary or traditional income documentation.

Conventional Loans

Conventional loans are a standard mortgage option available through most lenders and are often preferred due to their competitive rates and terms. For self-employed borrowers, eligibility requirements can be stricter than for salaried applicants. 

Lenders generally require:

At least two years of self-employment history
Proof of consistent income over the past couple of years

Unlike bank statement loans, conventional loans require a thorough review of your income history. This includes submitting tax returns, profit and loss statements, and any other documentation that verifies your self-employed income.

Qualifying for a Self-Employed Mortgage

Here’s how you can improve your chances of getting approved: 

Improving Your Debt-to-Income Ratio

Your debt-to-income ratio (DTI) is one of the key factors lenders look at when determining how much you can borrow. A lower DTI generally increases your chances of approval.

• Pay down high-interest debt: Focus on reducing credit card balances or personal loans that can increase your DTI.
  
  
• Avoid taking on new debt: Keep your debt levels steady to ensure your DTI doesn’t rise during the mortgage application process.

Increasing Your Income

• Diversify your income streams: Try increasing your business income or find additional sources of income to improve your monthly earnings.
• Increase earnings through business growth: Increasing revenue can help improve your DTI and overall borrowing capacity.

The Importance of Gross Monthly Income

Your gross monthly income plays a critical role in both mortgage eligibility and your DTI calculation.

• Lenders will first assess your gross income to determine how much you can afford to borrow. This is the total income you earn before any business expenses are deducted. A higher gross income increases your borrowing potential.
• The higher your gross monthly income, the lower your DTI will be (if your debt remains the same). This can work in your favour, as lenders are more likely to approve loans for borrowers with lower DTI ratios.

Mortgage Application Process for Self-Employed Borrowers

As a self-employed borrower, the mortgage application process requires additional documentation and verification. 

Here's what you’ll need: 

Compiling Proof of Self-Employment Income

Tax Returns

Bank Statements

Profit and Loss Statements

• Employment Verification
  Lenders may request additional documents to verify your employment status as a self-employed person. This could include:
  
  

  Business License

  Business Insurance

• Additional Verification Requirements:
  In some cases, lenders may ask for further verification if they need more confidence in your income stability. This could include providing contracts or agreements with clients or showing a history of consistent earnings.

Mortgage Requirements for Self-Employed Borrowers

You might face challenges when applying for a mortgage, but with the right approach, you can successfully navigate the process. 

Here’s a breakdown of the key requirements and strategies to increase your chances of approval:

Income Verification

You must provide detailed documentation to verify your income. Unlike salaried employees who can rely on pay stubs, self-employed individuals need to show a consistent history of income.

• Tax Returns
• Business Tax Returns
• Profit and Loss Statements.
• Bank Statements.

Comparison with Salaried Employees

The documentation and verification process for self-employed individuals differs from that of salaried employees:

• For Salaried Employees: Lenders ask for pay stubs and W-2 forms as proof of income. This is relatively simple since the income is steady and predictable.
• For Self-Employed Borrowers: The process is more complex because income can fluctuate. Lenders need to see tax returns, business records, and sometimes even contracts with clients to confirm that your income is stable enough to support a mortgage.

These additional steps are necessary to ensure that self-employed individuals have consistent and reliable income over time.

Tips for Self-Employed Borrowers

Here are a few strategies to improve your chances of securing a mortgage:

1. Making a Larger Down Payment

A larger down payment can make a big difference in your mortgage approval. Lenders view a larger down payment as a sign of financial stability and commitment, reducing the perceived risk. 

Additionally, a larger down payment lowers your loan-to-value ratio (LTV), which can improve your mortgage terms and help you qualify for better rates.

2. Choosing the Right Mortgage Company

It's important to compare lenders and look for one that has experience working with self-employed individuals. 

Lenders who are familiar with self-employment income will understand the documentation requirements and may offer more flexible terms. 

Improving Your Credit for Better APRs

When applying for a mortgage, credit history and your credit score play a significant role in determining the Annual Percentage Rate (APR) you’ll be offered. 

Lenders use your credit score to assess your reliability as a borrower, and a higher score generally leads to a better APR, which means lower interest rates and overall loan costs.

Here’s how you can improve your credit and increase your chances of getting a better APR:

• Check Your Credit Report for Errors: Review your credit report regularly to make sure there are no mistakes or outdated information that could hurt your score.
• Work on Improving Your Credit Score: If your score is on the lower end, take steps to improve it. Pay your bills on time, reduce high balances on credit cards, and avoid opening new credit accounts right before applying for a mortgage.
• Understand the Impact of Credit on APR: Your credit score directly affects the APR lenders offer you. A higher credit score generally results in a lower APR, while a lower score can lead to higher rates.

Frequently Asked Questions

1. Do mortgage lenders typically prefer gross or net income for self-employed applicants?

Lenders generally favour net income because it reflects the actual amount of money you have after business expenses, giving a more accurate picture of your ability to repay a loan.

2. How can self-employed borrowers improve their chances of mortgage approval?

To improve your chances of approval, focus on improving your debt-to-income ratio (DTI), keeping a consistent income, providing accurate and thorough documentation, and considering a larger down payment to reduce the lender’s risk.

3. What documentation is necessary for self-employed individuals applying for a mortgage?

Self-employed borrowers typically need to provide two years of tax returns, bank statements, profit and loss statements, and possibly business tax returns or a business license to verify their income.

4. Are there specific mortgage products aimed at self-employed individuals?

Yes, bank statement loans and conventional loans are two common options. Bank statement loans use income from bank deposits, while conventional loans require detailed income documentation like tax returns.

5. How does the debt-to-income ratio impact self-employed mortgage applicants?

Your DTI ratio is a key factor in the approval process. A lower DTI ratio indicates you can handle more debt, which increases your chances of getting approved for a mortgage. Reducing debt and increasing income can help improve your DTI.

Conclusion

If you're self-employed and feeling overwhelmed by the mortgage process, you're not alone. 

Understanding the difference between gross vs. net income can make a big difference in how lenders evaluate your application. Most lenders focus on net income since it reflects your actual earnings after business expenses. By managing your DTI and organizing the right documents, you can improve your chances of approval.

If all this feels a bit too much to tackle alone, Truss Financial Group is here to help. We can guide you through the process and help you secure the best mortgage for your situation.

Ready to take the next step in securing the right mortgage? Get in touch with us today!