Self-Employed Mortgages

Did you know that over 15 million people in the US are self-employed? The freedom and flexibility of being your own boss can be great, but it also makes it hard to get a mortgage.

The answer? Self-employed mortgages.

A self-employed mortgage is designed for those who earn a non-traditional income. Unlike standard mortgages, lenders rely less on pay stubs and more on tax returns and bank statements to verify income stability.

In this guide, we’ll dive deep into the application process and requirements of self-employed loans.

Understanding Self-Employed Mortgages

Homeownership is never easy, but self-employed individuals face an extra hurdle: the mortgage process. Traditional mortgages are geared towards salaried employees with W-2s. Meanwhile, self-employed mortgages take a different approach to income verification and approval.

Traditional vs. Self-Employed Mortgages

The key difference between these two mortgages is the documentation.

Getting a traditional mortgage is pretty simple. Borrowers provide recent pay stubs and a letter of employment verification from their employer. Lenders assess their income stability and calculate a debt-to-income ratio (DTI), and voila!

On the other hand, self-employed borrowers must offer much more. Lenders will request tax returns for the past 2–3 years, along with bank statements, business licenses, and profit-and-loss statements. They’d also want to learn more about your business and future projections.

Common Challenges of Self-Employed Mortgages

Self-employment creates a few obstacles when applying for a mortgage.

For instance, income variability is a huge concern for lenders. Salaried employees have predictable paychecks, making them easier to count on. Since self-employed income can fluctuate, lenders don’t have a baseline to calculate the loan amount you qualify for.

Then, there’s the lack of traditional employment verification. Without a W-2 or pay stubs, lenders rely heavily on tax documentation. However, self-employed individuals may have deductions and write-offs that decrease their taxable income, which means they can borrow even less.

Plus, some lenders may be hesitant to approve mortgages for businesses that are relatively new (less than 2 years old).

Benefits of Self-Employed Mortgages

On the other hand, self-employed mortgages do have their own advantages.

Some lenders may be willing to offer flexible terms that take into account seasonal income fluctuations. Depending on your business structure and profitability, you may even qualify for a bigger loan than salaried borrowers. If you’re borrowing for a hefty down payment, you may be in luck.

Qualification Criteria

Income Documentation

Self-employed borrowers can’t rely on pay stubs to prove their income. Instead, lenders request copies of your federal tax returns for the past 2–3 years. These returns should be filed with the IRS and reflect your business income after deductions and expenses.

They may ask for profit-and-loss (P&L) statements for your business. This way, they get a clearer picture of your business's revenue, expenses, and overall profitability over time.

Bank statements for your business and personal accounts for the past few months may also be scrutinized. Lenders use these to assess your cash flow, spending habits, and ability to manage finances.

Credit Score Requirements

Just like traditional mortgages, a strong credit score will get you better interest rates. According to the Federal Housing Administration (FHA), in 2023, the minimum credit score requirement for a self-employed borrower was around 500. Still, many lenders may prefer scores closer to 700 or higher.

Down Payment and Equity

A bigger down payment can also make you look more reliable to the lender. The minimum down payment varies based on the loan type, but generally, a 20% down payment is good enough. It shows that you won’t default on the loan since you also have a major stake in the property.

If you’re going to refinance an existing mortgage while self-employed, keep equity in mind. That’s the portion of the home you actually own. The more equity you have (preferably 20% or more), the more willing lenders are.

Financial Preparation

Qualifying for a self-employed mortgage requires quite a bit of financial preparation. Here are some key steps to help you out.

Organizing Financial Documents

1. Always keep several copies of your federal tax returns for the past 2–3 years on you.
2. Maintain clear and up-to-date P&L statements for your business. These should detail your income, expenses, and net profit over the past few years.
3. Collect several months of bank statements (both business and personal) that showcase your consistent income flow and responsible financial management.

Reducing Debt

The debt-to-income ratio (DTI) compares your monthly debt obligations to your gross monthly income. Mortgage lenders swear by this metric. A lower DTI shows that you’re able to manage debt, so you deserve the mortgage approval. Most lenders often prefer a DTI of 36% or lower, but some may accept DTIs up to 55%

Here are some strategies to reduce debt:

• Prioritize High-Interest Debt: Focus on paying off credit cards and other high-interest debts first. You can consolidate high-interest debts into a lower-interest loan to speed up the payments.
• Develop a Debt Repayment Plan: This could involve putting aside a bit of your income each month for debt repayment. Don’t forget to research different debt repayment methods, such as the avalanche or snowball method.
• Avoid Taking on New Debt: Steer clear of new debt like car loans or personal loans. This can negatively impact your DTI ratio and get in the way of your mortgage approval.

Building Savings

Saving for a bigger down payment makes you a more reliable self-employed borrower – here’s what to keep in mind:

• Create a budget! Track your income and expenses to find out where you can cut back for more savings.
• Set up automatic transfers from your checking account to your savings account. With the temptation to spend that money out of the way, saving gets much easier.
• Explore different income streams. You’ll be surprised at how much freelance work or side hustles can contribute to your down payment savings.