Navigating the Mortgage Maze: A Guide for Self-Employed and Non-Traditional Income Borrowers
You did it! You went out on your own with a great idea and built your business – and now you’re making a living doing what you love most: working for yourself. From one-person-shop plumbing businesses to freelance writers to personal trainers to small business owners of all shapes and sizes, the U.S. Bureau of Labor Statistics reports that there are 9.6 million self-employed people in the United States as of November 2022.
If you’re one of the millions of people out there that call yourself “boss,” you may also be wondering: what do I need to do to buy a home? Can someone who is self-employed get a mortgage?
Securing a home loan for self-employed individuals is more challenging than you might think. The number one consideration lenders use to determine loan worthiness is stable income – and this rule applies to anyone seeking out a loan. When someone applies for a loan, their income is typically reported to banks using traditional documents like W-2s, paystubs and even letters from employers. If you’re self-employed, these documents simply don’t exist. Banks also like consistency when it comes to knowing your income. As a self-employed individual, you may know that your income will be consistent – but you’ll need to prove it in concrete ways the bank can see.
So what are the options available for a self-employed person seeking a home loan?
With preparation and a little planning, you can secure a loan. Consider these important factors so you’re ready.
Be Ready to Demonstrate Income Stability
According to consumerfinance.gov, self-employment income is considered stable and effective if the consumer has been self-employed for two or more years. This is an essential consideration for banks since they look at long-term patterns of income, whether you are self-employed or a traditional employee. In fact, demonstrating your monthly income and financial health is crucial in any situation, but even more so when you are self-employed.
From a bank’s point of view, you’re considered self-employed if you have at least 25% ownership in a business. But not all businesses are “corporations” in the traditional sense. They can be sole proprietorships as well as partnerships. In today’s gig economy, independent contractors are a big part of the self-employed labor pool.
During the application process, you’ll need to provide proof of income by submitting various documents to prove your financial standing. According to the Consumer Financial Protection Bureau (CFPB), this documentation includes:
- Personal tax returns from the last two years. These returns will need to be signed and dated and include all applicable tax schedule documents.
- Business tax returns from the last two years. Only corporations, “S” corps and partnerships will have these returns. If you’re a sole proprietor or independent contractor, you won’t. Instead, you will need to provide photocopies of all 1099s received within the last two years.
- A profit and loss (P&L) statement and balance sheet. If you’re an independent contractor, this is Schedule C from your tax documents.
Gathering these documents ahead of time will help you streamline the approval or pre-approval processes.
Know Your Debt-to-Income Ratio
Lenders use a lot of different calculations to determine not only how much to let you borrow, but also if they are willing to extend a loan offer to you at all. One of the most common numbers used is what’s called a debt-to-income ratio. This number looks at the percentage of debt you already have in relation to the income you earn. Lenders will consider outstanding credit card debt, any car or student loans, and other known expenses – like insurance or homeowner’s association (HOA) fees that will come along with your new condo or property. Other fluctuating expenses, like groceries and gas, will be estimated by the bank. In general, consumer advocacy groups recommend homeowners carry a debt-to-income ratio of less than 36% — meaning only 36% of your income goes to pay your monthly expenses. However, some lenders will approve mortgages even if your debt-to-income ratio is 43% or higher. Here’s a great tool from consumerfinance.gov for calculating your debt-to-income. If your ratio seems high, remember that paying off debts will help lower it, making your loan application more attractive to lenders. Also, if you know you’ll be in the market soon for a home loan, resist the urge to take on new debts.
Review Your Credit Score & Reports (And Strengthen That Score if Needed)
Your credit score is an essential factor in determining your loan worthiness, and it can also help banks decide the interest rate to offer you. For some loans, including a conventional home loan for self-employed individuals, lenders usually require a minimum credit score of 620 unless a large down payment is made. Your credit rating is an indication of your financial strength and credit history, and it is a major factor that lenders look at when you apply for a mortgage.
Before you begin the mortgage application process, it’s a good idea to obtain a copy of your credit report from all three major credit bureaus, including Experian, Equifax, and TransUnion, to ensure that your information is accurate. You can get a free credit report from each bureau once every 12 months by visiting annualcreditreport.com. Reviewing your credit report can help you identify any inaccuracies and fix them before you begin the mortgage application process. The Consumer Financial Protection Bureau (CFPB) offers a checklist to help consumers review their credit reports, including information on how to contact the credit bureau to dispute any errors.
If your credit score is lower than you’d like, it’s possible to raise it. One of the ways to achieve this is to keep your current debts low, and avoid taking on additional debt. Additionally, it’s essential to make all your payments on time and in full each month. Paying your bills on time every month and resisting the urge to max out your credit cards can positively impact your credit rating. Also, avoid rushing to close credit accounts, especially if you have a history of paying certain credit cards on time for a long time. Keeping those accounts open will demonstrate how responsible you are with your debt obligations, and help you maintain a healthy financial strength. When applying for a mortgage, it’s important to be aware of your monthly debt payments, which include credit card balances, car loans, and other loans. Lenders will want to know that you can comfortably manage these payments while also paying your mortgage.
Save as Much as You Can for a Down Payment
The amount you save for your down payment can also help you look more appealing to banks and credit unions. In fact, the CFPB states that making a 20% down payment increases your chances of getting approved for a loan.
While saving this much for a down payment can seem challenging, it can boost your ability to secure a loan. Plus, by putting down at least 20%, you might qualify for a better interest rate. You’ll also avoid having to pay Private Mortgage Insurance (PMI). PMI benefits your lender, often in the form of an additional monthly payment you make along with your mortgage. Lenders impose PMI to make sure their loans are insured when lending more than 80% of the value. Avoiding PMI is not only a smart financial decision, it can lower your debt-to-income ratio.
The Best Mortgage Lenders for Self Employed Individuals
Typically, self-employed borrowers wonder if there are loans or lenders out there designed for them. After all, there are VA loans for Veterans and FHA loans for first-time homebuyers or higher-risk borrowers. The good news is that all of these loan types and more are open to self-employed borrowers.
Conventional loans are open to any borrower with a good credit score and steady income, including self-employed borrowers. This includes a traditional fixed or variable rate home loan for self-employed individuals. There are also self-employed loans available for those who need specific lending options for their business.
Government backed loans offer more flexible credit guidelines and are also available to self-employed individuals that meet the requirements:
- FHA Loans: These loans are insured by the government and offer an excellent option for self-employed mortgage applicants who have a low down payment or less-than-ideal credit. However, they require specific conditions be met for the property, which can sometimes get in the way if you make an offer on a home in a competitive housing market where other offers on the table don’t have FHA loans.
- VA Loans: These loans are sponsored by the U.S. Department of Veterans Affairs. They are open to eligible veterans and active-duty members of the U.S. Armed Forces. These loans are often available with no down payment and no PMI.
- USDA: These are government loans available to rural families and individuals with low and moderate-income.
The best advice is to shop around to find the best rates and lowest closing fees. This will lead you to the best mortgage lenders for self-employed borrowers. If you have the necessary documentation to prove your income stability, a good credit score and a healthy down payment – you’re in the driver’s seat. In many cases, you might find the best rates from a neighborhood credit union instead of a large bank. Plus, the personalized service can help you when pulling together the documents you’ll need for your loan.
Is a Preapproval Necessary for a Loan if You’re Self-Employed?
For self-employed applicants and first-time home buyers, it’s also a good idea to consider getting a pre-approval from the bank you choose. It can give you a competitive edge when making an offer on a home and demonstrates to sellers and their realtors that you’re committed to buying a home. Applying for preapproval is also a good “trial run” for applying for a mortgage since you’ll need to supply all the same paperwork and documentation related to credit worthiness and income.
Read More – Why it’s Critical to get a Home Mortgage Pre-approval
What’s Next? Understanding Underwriting
Every time a bank or credit union loans an individual money, they run the risk of that person not paying them back. During the mortgage process, the underwriting process is used to assess this risk for a bank. All information related to creditworthiness, income, employment history, and self-employment status will be reviewed. The review process can take several weeks to complete, depending on the financial institution you borrow through. You’ll be assigned an underwriter who will outline all the steps you’ll need to take and documents you’ll need to submit. It’s important to communicate your self-employment status to your loan officer. Working with a smaller bank or credit union can work in your favor as underwriters are often not contracted out and will have more open communication with your assigned loan professional. Responding in a timely manner to any requests for additional documentation will help you complete the underwriting process quickly. This will allow you to proceed with shopping for the home of your dreams once you are approved for a conventional mortgage.
Securing a Home Loan is Possible if You’re Self-Employed
If you’re self-employed or a contract worker, it IS possible to get a mortgage. Preparation and planning, including saving up for a strong down payment, can go a long way to helping you increase your chances for approval – and get through the loan process quickly.
You also don’t have to go it alone. Reach out to your local bank or credit union to get started and get advice along the way.
