You work for yourself, which means your finances look a little out of the ordinary or different than a standard salaried employee. Luckily, this does not preclude you from securing a mortgage. Yes, you have to do more legwork to secure the loan, but there are options available to you. Before you start the process, consider these steps to best prepare you for the process.
File Your Taxes
No one likes to file his or her taxes, but you have no choice, whether you are self-employed or not. On top of filing, you have to file them right. Don’t lie about your income and don’t take too many deductions. Sure, no one wants to pay more taxes than they have to, but too many deductions can hurt your chances of securing a mortgage. Any lender, no matter who you use, will look at your tax returns or tax transcripts. They use the bottom line income that you claim as your net income. If you write off too many expenses, think of it as knocking your qualifying income down. Unless you have a great debt to income ratio already, this is probably something you don’t want to do.
Figure Out What you Can Afford as a Self-Employed Borrower
What you think you can afford and what you can actually afford probably don’t align. Most loan programs require a front-end debt ratio no higher than 28 percent, give, or take a percentage point. This means out of the income you claim, your mortgage payment can only equal 28% of it. In addition, mortgage payment means – principal, interest, real estate taxes, and homeowner’s insurance. If you need to pay a homeowner’s association or mortgage insurance, that gets factored in as well. Finding a home not located in an association can help. Also, putting down at least 20% can eliminate PMI.
Once you know what you can afford on the front end, don’t forget about the back-end. These are your total debts. Think of any debt reporting on your credit report. For example, credit cards, student loans, car payments, and personal loans – they all report. This means the lender must include them in your monthly debt ratio. Add these expenses (minimum payments for credit cards) to your total mortgage payment. This number cannot equal more than 36% of your claimed income. Now you have a better idea of what you can afford.
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Check Out Your Credit
Your credit score and credit history plan an important role too. Since you are self-employed, you already pose a higher risk to the lender. This means they probably want to see a good or excellent credit score. Technically, this means a score over 700, but some lenders will allow one as low as 680.
Aside from your score, the lender will look at your credit history. How much debt do you have outstanding compared to your available credit? How well do you make your housing payments if you have a mortgage now? How many late payments do you have on any other type of debt over the last year? These things play a vital role in how the lender looks at you and the risk you pose.
Get Compensating Factors
We already talked about how risky you look to a lender as a self-employed borrower, so now it is time to show them you are not risky. You do this with compensating factors. Here are a few examples:
- Reserves – The more money you have on hand, the less risk you pose to the lender. Aside from your down payment, show the lender that you have money saved in an emergency fund. The lender will measure these funds based on how many months’ of mortgage payments they cover. This gives the lender reassurance that you could still pay your mortgage should your income suddenly stop.
- Low debt ratio – Your debt ratio plays an important role when you are self-employed; sometimes even more so because of it. You already pose a risk to the lender working for yourself. If you have a high debt ratio, it exacerbates the risk the lender takes on you. A low debt ratio, on the other hand, gives the lender reassurance that you will be able to pay the loan without fail.
- Adequate experience – Showing that you have plenty of experience in the industry your business is held can also help. This shows the lender that your business is not a “fly by night” idea. Instead, you have a good working history in the industry, understanding its ins and outs. This helps to reassure a lender that your business is here to stay.
Have Adequate Documents
Aside from your need to show your income on your last two years’ worth of tax returns, you need other business documents to help prove your business. These may include:
- Business license
- Letter from your CPA confirming your role as business owner
- Letters from clients and/or vendors who you do business with
- A current Profit/Loss Statement
The more “official” your books look and the more documents you can provide a lender, the more legitimate your business will look. This will serve as another compensating factor for you when you try to get a loan as a self-employed borrower.
Once you have everything together, you get to start shopping for a lender. Not every lender will welcome you with open arms no matter how good your credit is or how many compensating factors you have. As long as you prepare yourself for quite a project ahead of you, your patience will pay off. Eventually you will find a lender willing to lend to you, whether it is a large bank or a small lender with their own portfolio loans. Make sure you weigh all of your options and make the choice that not only fits your financial needs now, but well into the future as well. This will help prevent the risk of foreclosure by getting yourself in over your head.
