Qualifying for a Mortgage for the Self-Employed

Many potential home loan borrowers that are self employed believe that it is much more difficult to be approved for a new mortgage if you are self employed.  While it can certainly be difficult for a self-employed buyer to qualify for a mortgage, the qualifying standards for a self employed borrower and the qualification standards for a wage earner or salaried borrower are the same.

The difficulty with the approval process is not with different underwriting standards it is simply that self employed borrowers often have irregular income and unsubstantiated savings or reserves.

It is often difficult for the self-employed individual to predict cash flow and business profits on a regular basis, making a self employed borrowers income highly variable.  It is that variable income that presents the biggest obstacle.

Complicating the matter even further, in the past, mortgage lenders made a whole host of mortgage to self employed borrowers that were low and no documentation loans.  A large portion of these home loans have since gone into default, casting self-employed home buyers in a negative light and making mortgage lenders hesitant top offer any home loan products with additional layers of risk available to self employed borrowers.

Self-employed borrowers must demonstrate an appropriate net income before they can obtain a home loan.  This guideline is no different than it is for a wage earner applying for a home loan.  Standard mortgage guidelines call for verification of a two year average of monthly income. 

This is true whether the borrower is self employed or not.  Sometimes automated underwriting systems will require only a one year verification of income, this may be found in some case where borrowers have very high credit scores and large down payments or savings.  Conditions in which a borrower has very high credit scores or large accumulated savings is referred to as compensating factors.

Two years of consistent, verifiable income can be difficult sometimes for those that are self employed, as many self-employed business owners take a great deal tax deductions each year and deduct as many expenses as they can from their gross business revenue, lowering their tax bill but also lowering their net income.  This makes it hard for self-employed borrowers to show, on paper, that their business has a high earning potential or more importantly that the average of the business income actually qualifies for a mortgage loan based on the proposed mortgage payment and other debts of the borrower. 

The problem with the self employed fundamentally rests the inability to produce filed tax returns that have sufficient monthly income to qualify for the home loan request.

Self-employed borrowers will generally have to provide a great deal of documentation to the potential mortgage lender to verify their income.  This is because there is more room for self-employed individuals to embellish or exaggerate figures, so everything must be documented appropriately.  A wage earner has less documentation to supply since the verification process is far easier as it generally involves the most recent w-2, current pay stubs and verification in writing or verbally of present employment.  Clearly, that process would yield very little relevant information for the mortgage lender on a self employed borrower.  In addition to standard loan paperwork, a self-employed borrower may also be required to provide the following:

Two years personal income tax returns
Two years of business income tax returns
A profit and loss statement

The following calculations are used by mortgage lenders to calculate the income of self-employed applicants – the applicant’s net income for the past two years based on the filed tax returns plus depreciation declared from the business.  This gives a monthly average income that can be used to qualify for a home loan.  Year to date income is measured but almost always ignored for qualification purposes as it can not be adequately verified.  Expenses paid out of the business are not added back in to help increase the income, declared net income plus depreciation is the standard rule for calculating self employed borrower’s income.

If self-employed borrowers experience a great deal of difficulty when qualifying for a loan, they may consider alternative financing options other than a fully documented loan.  One such option is stated income.  These home loans have been sharply curtailed recently and are reserved for borrowers with excellent credit and substantial equity.  Alternative documentation loans are suffering the same fate, however there are still programs available that allow alternatives such as the use of bank statements which add up the last 12 months of deposits to calculate an average monthly income. 

Other options may include the compensating factors.  A borrower who has limited income and therefore a high debt ratio may be able to qualify for a mortgage loan with a large down payment or large reserves after the down payment.  In addition, have exceptional credit scores and limited debt outstanding will also help grease the wheels for a home loan approval.

The last resort may be seller financing.  Sellers may require some credit checks, but may not require such extensive paperwork to verify income.  The terms almost certainly will be less generous as well.

Though the paperwork for the self employed borrower may be more burdensome, if the income is consistent and the appropriate tax returns are used, there should be very little problems qualifying for all mortgage loan types.  To check the possibility of qualifying for a home loan, a mortgage calculator can used to first calculate a two year average of monthly income and then the qualifying mortgage debt ratios.  The mortgage calculator can be used to check debt ratios for a variety of home loans to see how well a borrower may meet the standard underwriting guidelines. 

Home loans to purchase a property or for a mortgage refinance will have the same income qualification requirements for the self employed borrower.  Good documentation is the key to a fast and painless home loan approval.