The following is a post by MPFJ staff writer, Kevin Mercadante, who is a freelance professional personal finance blogger for hire, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
If you’re self-employed and have applied for a mortgage, you probably have a sense that you were put through a meat grinder. And if you’re self-employed and have merely heard how difficult it is to apply for a mortgage when you’re self-employed, I’m here to tell you that it’s all true.
I spent more than 15 years in the mortgage industry as both an underwriter and a loan originator, and I saw this unfortunate bias against the self-employed again and again. People who are paid by W-2 can often squeak into a mortgage with a shoehorn, but the self-employed must always be prepared to run faster and jump higher.
And even then there may be no guarantees.
The Bias Against the Self-Employed in the Mortgage Industry
I think most of us understand that the job market has become far less reliable since the financial meltdown, and probably going all the way back to the dot-com bust. But in the mortgage universe that doesn’t matter – lenders continue to view salaried employees as if they have a guaranteed income for life.
The reverse is true when it comes to the self-employed. The mortgage industry views the self-employed as if they’re one step away from destitution.
In a way, this view is not entirely without merit. Something like 80% of businesses fail within the first 18 months of operation; if you’re a lender, this is not a statistic that is easily ignored.
Businesses fail for all kinds of reasons, many of which are impossible to know upfront. This is the reason a mortgage lender will generally look for the self-employed person to be in business for at least two years. By contrast, a salaried worker coming out of college can often qualify for a mortgage simply with a promise of employment letter.
If you’re going to apply for a mortgage as a self-employed person, the first step is to recognize that it will be an uphill fight. The second will be to prepare yourself in advance. It’s not impossible to get a mortgage when you’re self-employed – just more difficult. That’s what you have to be ready for.
What the Mortgage Lender Will Be Looking For
The documentation requirements for self-employed borrowers are extensive. The laundry list reads something like this:
- Evidence that your business has been in existence for a minimum of two years – this may require a copy of a business license, a letter from a CPA, or a letter from a licensing bureau.
- Income tax returns for the past two years – this includes both personal and business returns, and all schedules.
- The lender will also verify your income information with the IRS.
- If any income will be needed from the current year, for which an income tax return obviously has not been filed, you’ll need financial statements provided by a CPA. Under certain circumstances, they may need to be audited statements, which can cost thousands of dollars.
- Your income will be averaged for the past two years. If your net income (not gross) was $100,000 in 2014, and $50,000 in 2013, your income for mortgage purposes will be $75,000 ($100,000 + $50,000 = $150,000, divided by two years).
- If your income for the most recent year was lower than it was for the previous year, your income will be based off of the current year, and not averaged.
- If your income for the most current year is significantly below what it was the previous year, your income may be considered unstable, and the loan application denied.
To put that in perspective, a salaried borrower only needs a copy of a recent pay stub, the previous year’s W-2, a verbal verification from their employer that they are still employed there and likely to be so in the future. The lender will also use current income for qualification purposes (no averaging), even if it has increased substantially from the previous year.
Your Response to Their Demands
If you want a mortgage, your only choice will be to comply with the lender’s requirements. Even if you don’t agree, you will not be able argue around any of those requirements. Since nearly all mortgages are sold to the same agencies (FNMA and FHLMC) or require mortgage insurance from either the FHA or the VA, the guidelines will be the same in all cases.
If you have not been in business for at least two years, you’ll need to be patient and wait until at least that much time has passed. You will also need to make sure that your business shows a pattern of increased earnings from year to year. This is not always entirely within your control, since business cycles can affect your bottom line.
But there is one thing that you can do, and that’s not be overly aggressive with deductions on your income tax return.
All self-employed people have a built-in disadvantage when it comes to applying for a loan of any sort. One of your primary objectives is income tax minimization. You will accomplish that by taking every deduction that the IRS allows. But that strategy works in reverse when you are applying for a mortgage.
The conflict is that filing income taxes focuses on income minimization, while applying for a loan requires income maximization. If you know that you will be applying for a mortgage in the near future, you will do well to go light on your income tax deductions.
Developing Strengths of Offset Your Weaknesses – a.k.a., “Compensating Factors”
A salaried person can often get a mortgage with a minimum down payment, less-than-perfect credit, and even a little bit too much debt. But if you’re self-employed, don’t count on getting similar treatment. Your financial profile will have to present a picture of a stronger borrower.
There is a term in the mortgage industry called compensating factors and while it applies to all borrowers, it’s generally most important to the self-employed. Compensating factors are indirect lending criteria that can make a borrower look stronger, even if that criteria is not strictly required.
Here are some examples of compensating factors that can help you if you are self-employed:
- Making more than the minimum down payment – if this is 5%, making a 20% down payment will make you a stronger borrower.
- Strong credit profile – most lending programs require a minimum credit score of at least 620; yours should be well in excess of 700.
- Cash reserves – this is the amount of cash that you will have available after closing. The typical requirement is liquid savings (not retirement money) sufficient to cover at least two months of the payment on the new home. You should have six months or more.
- More than the minimum self-employment history – it’s generally at least two years, but you should figure to be in business for at least three years.
- Not buy more house than you can afford – many borrowers buy a house that’s up to the maximum amount they qualify for. This is usually based on a debt-to-income ratio (DTI) of not more than 36%, and sometimes it can go higher. Make sure that the home you want to buy is keeps your DTI well below 36% .
- The increase in your house payment should be reasonable – lenders generally consider an increase in your house payment of up to 15% or 20% to be reasonable. A doubling of your house payment could make your loan too risky, and result in a decline.
If you can keep all those factors in mind, and develop a financial profile that largely matches them, your loan will be considered lower risk even though you’re self-employed. No, it’s not fair, but it’s how the mortgage world works. If you are aware of the obstacles – and have a strategy to overcome them – then you’ll get the loan you want.
How about you all? Have you ever applied for a mortgage when you are/were self-employed? What kind of roadblocks did you run into?
Share your experiences by commenting below!
***Photo courtesy https://www.flickr.com/photos/nikcname/4893848354/sizes/q/
