Self-employment comes with benefits and drawbacks, and it is more of a lifestyle than a job. The freedom of being your boss comes at the cost of looking like a risky investment for lenders. Yet, the dream a home is not out of reach for those who chose to pursue a different path than 9 to 5. It just takes more diligence, resilience, and paperwork to prove that you are as worthy as your cubicle counterparts.
Enhance your credit score
This is good advice for employees and self-employed alike. Having a high credit score proves healthy financial habits and recommends you as a trustworthy business partner for any financial institution. While regular employees can get a good rate with scores starting at 640, the requirements are raised with about 100 points for self-employed. This difference is a risk premium, due to the fluctuating nature of income in the latter case.
If you are just starting out on your own, keep in mind that most likely it will take at least two years until you can access a mortgage. Use this time to build both your business and your score by keeping a strict budget and paying off debt at a regular rate. At least 6-12 months before the moment when you anticipate you will require a mortgage stop opening or closing accounts or maxing out credit cards.
Build a solid earnings history
Most lenders will not even consider your application without at least two years of well-documented income history. Beware if they do, those are usually sub-prime mortgages with interest rates over 30%, which are hard to sustain in the long run. While employees just fill in the W2 form, you should prepare to bring proof of business track records. Also, provide balance sheets to emphasize profit and loss. The lender can even ask you to show copies after your contracts with various clients for cash-flow purposes.
It is important for the lender to know not only that you can afford the rate, but that you can sustain it over time. In your P&L statement, they will look at the numbers but also at the trend. It is important to have an upward trend, showing that your business is growing and that you can afford the mortgage and other expenses incurred by house ownership.
Self-employed for less than one year, don’t have too many options available. Between one year and two years, some lenders might consider your request, as long as you have been in the same line of work previously and you have positive financial statements from your first year. However, your case is still considered a risky one, and you might be granted the loan with a higher rate.
If you have a history going back at least two years, your lender will compute a monthly average and consider that as your reference income. Other banks take 120% of your lowest income as your reference rate. Be sure to ask the computational method when asking for a loan.
Decrease your debt to income ratio
Employees and self-employed alike need to have a debt to income ratio as low as possible to be sure they get the loan. So, before thinking about a house mortgage, it is time to eliminate other outstanding debts, including student loans, car payments or credit card debt. Try to do this in the two years before applying for a loan, as it will help you two ways: decrease your debt and grow your credit score.
While in the case of employees the income is the salary, for self-employed, the problem is trickier. Since you have deductible expenses, not all your earnings qualify as income. In fact, the biggest mistake independent workers make is taking out so many deductibles for tax purposes that they get such a modest income they don’t qualify for a loan.
The best advice here is to strike the right balance between avoiding taxes and deducting expenses just for the sake of it. A good rule of thumb is to subtract necessities, without becoming “creative” about it. That included counting your holiday expenses as a business trip.
Save for down payment and emergency funds
A solid down payment denotes that the borrower has the necessary financial power and has prepared for this. This decreases the lender’s risk. Prepare to have at least 20% in cash when requesting the loan to get a decent interest rate. Having about 30% puts you in a power position and grant you negotiation credibility.
A larger down payment (over 20%) helps you stay away from private mortgage insurance (PMI), which can be costly. The PMI is required when the loan is over 78% of the house’s value. If you drop below that value by making payments, you can ask your lender to remove the PMI.
Self-employed individuals also have to think about a less stellar moment in their business. Be extra careful if you rely only on a big client. Putting at least six months’ worth of cash in a deposit for rough times is a way of ensuring you don’t miss payments and you don’t jeopardize your home ownership.
Consider “add backs”
Taxable income and actual income are not always equal. I the case of self-employed, the lender could find a broad range of add backs. The list includes depreciation, one-off expenses, interest expenses, company car, net profit before taxes and more.
Keep in mind that for most add-backs you will need a letter from your CPA. The paper is necessary to give additional information such as contract numbers, invoice numbers, and other justifying documents.
This income increase is possible since your taxable income is not your actual income. Lenders are aware that you incur some expenses to diminish your taxable income, but these don’t affect your payment commitments. It is critical to eliminate from the list those significant costs that are not recurring.
Since the subprime crisis of the late 2000’s, it has become harder for self-employed to get a mortgage. A standard loan, like the one available for employees, is harder to get. As previously described, in similar conditions, only 60% of applicants get positive approval, when compared to regular employees.
Other options include Alt-A loans. Depending on the number of documents required you can have low documentation loans or no documents loans. For the low-doc, you provide no income statement, but you fill in forms 4506-T and 8821, which allow the lender to check you at the IRS. The form allows the bank to protect from false statements. The no doc option is only a last resort as it forces you to accept high rates. This is only acceptable for self-employed with a loss track record or small profits, but in this case, you should assess your ability to repay the loan.
If you have a relative, significant other or friend who is a full-time employee, another option is to co-sign the loan with them. If they accept, you can get a better rate by the stability their job provided to the borrower.
Getting a mortgage as a self-employed is a lot harder than for employees. However, by their entrepreneurial nature, these individuals can face the challenge in a better way. They just should use the know-how they got from their business in a different setting. They know how to budget, how to make a business plan and stick to it and they are less likely to engage in irrational shopping. Furthermore, self-employed are more likely to have a CPA and be more aware of their spending habits. This diligence makes it easier to cut down unnecessary expenses. The fact that these people are considered a riskier investment for lenders is not justified.