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.
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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.
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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
- Always keep several copies of your federal tax returns for the past 2–3 years on you.
- 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.
- 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.
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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.
Choosing the Right Lender
Finding the perfect lender is the most important part of a smooth self-employed mortgage journey. Here's how to navigate this aspect:
Researching Lenders
Not all lenders are created equal, especially when it comes to self-employed mortgages. In fact, 70% of borrowers have stated that some lenders wouldn't consider them because of their self-employed status. Luckily, you can still get a good deal by following these tips:
- Visit the National Association of Realtors (NAR) or mortgage broker websites to search for lenders offering self-employed borrowers. As of 2016, over 12% of homebuyers are self-employed, so it may not be as tricky to find the right fit now.
- Ask around! Get advice from friends, family, or self-employed colleagues who have recently bought a home.
- Consult a mortgage broker. Brokers work with the best lenders in the business and can shop around for the best rates and terms for you.
Comparing Mortgage Products
Once you've created a potential list, it's time to compare their mortgage products. Here are some key criteria to consider:
- Interest Rates: Even a slight variation in interest rate can seriously impact the total cost of your loan over time.
- Loan Terms: Pay attention to loan terms like the loan duration (15 vs. 30 years) and any prepayment penalties that might apply. The terms should align with your long-term financial goals.
- Down Payment Requirements: As discussed earlier, a larger down payment can strengthen your application and potentially get you a better deal.
Getting Pre-Approved
We seriously recommend getting a pre-approval letter before actively searching for homes. This letter from a lender estimates the loan amount you qualify for, so you get a clear idea of how much you can spend on your new home. The pre-approval process typically involves submitting financial documents and a credit check.
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The Application Process
Finally, you’ve chosen the right lender! Here’s what to do next.
Initial Consultation
You’ll start with an initial consultation with a mortgage advisor from your chosen lender. Here’s where you’ll discuss your financial situation, ideal loan amount, and homeownership goals. The advisor will offer different loan options, answer your questions, and guide you through the application process.
Submitting the Application
Once you've decided on a loan product, it's time to submit a formal mortgage application. You’ll need to provide the following documentation:
- Completed application form.
- Federal tax returns for the past 2-3 years.
- Profit and loss statements for the past few years.
- Bank statements (personal and business).
- Proof of income, like 1099 forms or contracts.
- Employment verification, like client contracts or letters of engagement.
- Proof of any savings accounts or investment portfolios.
Underwriting and Approval
Once your application is submitted, it goes through "underwriting." Here, a loan underwriter from the lender assesses your documents to see how risky it will be to lend you money. During underwriting, the lender may ask for extra details to clarify any aspects of your application.
Finally, upon successful underwriting, you'll get a loan approval letter outlining the final terms and conditions of your mortgage. You’re getting closer to achieving your homeownership dream!
Tips for Success
Congratulations! Getting a self-employed mortgage is a huge accomplishment. Here are some more tips to make sure your financial health stays intact during the process.
Maintaining Good Financial Habits
Even after securing your mortgage, you must maintain healthy financial habits. Here's how:
- Regular Savings: You can never go wrong with continuous saving. It helps you build a financial buffer for unexpected expenses or future homeownership goals like renovations.
- Debt Repayments: Make timely payments on your mortgage and any remaining debt to keep a good credit score. It’ll definitely come in handy in the future when applying for loans or other lines of credit.
Keeping Comprehensive Records
Detailed record-keeping is a must-have skill for self-employed individuals, particularly homeowners. Here's why:
- Tax Season Efficiency: Create organized records of your yearly income and expenses. Once tax season rolls around, you’ll pat yourself on the back. You’ll have all the necessary documentation readily available.
- Future Loan Applications: Keeping clear financial records also allows you to create a history of consistent income and financial stability. If you decide to apply for additional loans in the future, like a home equity line of credit (HELOC) for renovations or improvements, this stability will definitely vouch for you.
Seeking Professional Advice
If you can afford it, consult a financial professional to shape up your financial well-being:
- Financial Advisor: A financial advisor can help you create a long-term financial plan. That’ll include your retirement goals, investment strategies, and wealth management.
- Tax Professional: A tax professional will help you make the most of all available deductions and credits available to self-employed individuals. It’s your best opportunity to maximize your tax savings and free up extra funds for future financial goals.
Common Pitfalls and How to Avoid Them
As a first-time borrower, certain roadblocks can make or break your application's success. Here are some common pitfalls to avoid:
Incomplete Documentation
Many self-employed borrowers tend to struggle with incomplete documentation. Remember, lenders rely heavily on your financial records to assess your eligibility. Here's how to ensure you have everything covered:
- Don't wait until the last minute to collect your documents. Start assembling your tax returns, P&L statements, and bank statements well before applying for a mortgage.
- Take a second look at your lender's documentation requirements and make sure you have everything on the list.
- Maintain a well-organized system for your financial documents. Trust us – it’ll save you tons of time and frustration during the application process.
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Overestimating Income
It might be tempting to inflate your income on your application. However, this is a risky strategy.
Sure, it’s not as easy as a salaried income, but lenders can still verify the income of a self-employed individual. Misrepresenting your income can lead to application denial or even loan fraud charges.
Instead, use your past tax returns as a guide to realistically estimate your average annual income. If your income fluctuates throughout the year due to seasonal factors, work with a mortgage broker. They’ll calculate a smoothed-out average that actually reflects your earning potential.
Ignoring Market Conditions
The mortgage market can seem chaotic to a beginner. If you want a good deal, keep a close eye on the current mortgage interest rates.
You’ll need to adjust your budget or timeline based on market conditions, too. If interest rates are rising, it may be best to go for a smaller loan amount to stay within your affordability range.
Conclusion
Over 25% of self-employed individuals find it hard to get a mortgage, with 96% stating that they have to provide more paperwork than a salaried worker. But don’t be discouraged! Now that you’ve read our guide, you can get your hands on a generous self-employed mortgage.
For expert guidance, contact Truss Financial Group today.
