2023 Mortgage Guide for the Self Employed

Self-employment has many advantages: You get to be your own boss, make higher-level decisions, rise to challenges, take advantage of tax breaks and, perhaps, make a lot of money. However, there are disadvantages, too — something that becomes very obvious when you try to finance your first home. Here's what you need to know to pass muster as a self-employed home buyer.

In mortgage lending, an applicant is self-employed if he has more than 25 percent ownership in an active business — a sole proprietorship, partnership or corporation. Any income for which you receive a 1099 form at tax time is considered self-employment income by lenders, and you'll have to hop through some hoops if you want it considered in your loan application.

Even if you don't plan to use self-employment income to qualify, lenders will want your tax return to make sure you aren't losing too much money. If you write off business losses against other income, underwriters may subtract these losses from your qualifying income.

Many mortgage writers and lenders say self-employed applicants are not held to a higher standard than W-2 employees. That's true — sort of. Self-employed borrowers have to hit the same credit, income and asset marks that wage earners do, although proving their income can be a bit more challenging.

Whether you are self-employed or a W-2 employee, lenders want to see that your income is:

• Ongoing. Expected to continue for at least three years
• Stable. It comes regularly and predictably
• Sufficient. As evidenced by your debt-to-income ratios.
• Lenders also want to see that you have enough assets to cover your down payment and closing costs. Additional savings, called reserves, are beneficial, and lenders like to see reserves because you can use them to pay your mortgage if your income is interrupted.

Lenders typically look at three main qualification requirements. Before you begin the homebuying process, it may be a good idea to review your credit score, assets and accounts, and debt-to-income ratio. This way, you know where you stand, and there are no surprises.

Minimum FICO scores generally range from 500 to 680 for most home loans but they don't always tell the whole story. The Federal Housing Administration (FHA) allows credit scores as low as 500, for example, but only a small number of loans are approved at that level. In fact, according to mortgage data from Ellie Mae, the average FICO score for successful home loan applicants is 729. In general, lower scores may be offset by larger down payments, conservative use of credit, reserves, and low DTI ratios. Don't expect to get a loan with a mediocre score if there are other layers of risk — income instability, a tiny down payment, or the absence of emergency savings.

Lenders impose higher credit requirements when they are concerned about other risks in an application package, and for some lenders, that includes self-employment.

These are broad strokes; there are many fine points associated with qualifying for a home loan, and yes, it is more complicated when you're self-employed. An experienced and knowledgeable loan officer can be a real lifesaver when you're self-employed.

Assets include savings, checking, investment and retirement accounts that can be used to cover down payments, closing costs and reserves. Some programs allow gifts and seller contributions in addition to borrower savings. Down payment requirements range as follows.

*USDA
**VA loans

Some programs impose higher reserve requirements for self-employed borrowers because their income may be viewed as less stable. One month of reserves includes the cost of your mortgage principal, interest, taxes and insurance (PITI). That means if these mortgage expenses total $1,000 per month and you would have $4,500 in savings after closing on your mortgage, your reserves equal 4.5 months.

Your monthly bills, together with your income, are used to calculate your debt-to-income ratio, or DTI ratio. DTI ratios comes in two flavors — a top, or front-end ratio, which is calculated by dividing your prospective housing expense by your gross (pre-tax) income.

The second DTI ratio is called the bottom or back-end ratio. It's considered the more important of the two. The back-end ratio equals your housing expense plus your other monthly bills (auto loan and credit card payments, student loan payments, etc., but not living expenses such as utilities) divided by your gross income. The general rule is front-end ratios less than 28-32 percent and back-end ratios maxing out at 36-40 percent are in the acceptable range, but it is possible to get approved with a slightly higher ratio, depending on your credit profile.

Debt-to-Income Ratio Calculator

The differences between self-employed and W-2 applications fall into six categories, which are explored more in-depth below. You can click on the menu below to learn more about these differences and get tips on how to get your application past an underwriter.

For most mortgage applicants who receive W-2s, documenting their income is easy. They submit copies of their most recent two pay stubs and W-2s covering the last two years. Unless they have a lot of investment income, tax-deductible employee expenses or earn commissions, tax returns are not required. These mortgage applicants also provide copies of their bank, investment and retirement account statements, and the underwriter will pull their credit report, check their FICO scores, and analyze their expenses. If the credit is satisfactory and the income sufficient, the applicant will probably be approved.

For self-employed applicants, however, the requirements are more burdensome. In addition to the credit report and personal account statements listed above, self-employed mortgage-seekers have to submit their company's account statements, personal tax returns, business tax returns, year-to-date balance sheets and profit and loss statements, and sometimes a copy of their business license, legal filings (such as articles of incorporation), and letters from CPAs detailing the health of the business and the stability of its industry.

When you are self-employed, some of your income may not be used to get you qualified for a mortgage. For example, if you work off the books and accept undocumented cash payments, that income does not count. For W-2 mortgage borrowers, the amount shown on their pay stubs or W-2 form is usually what the lender uses when evaluating their application. Self-employed applicants are often shocked, however, when they list their gross income on their application and their lender cuts it down — sometimes way, way down. Most tax write-off don't just reduce your taxable income — they also lower your qualifying income.

It gets worse: Any income that's not a regular part of your business gets thrown out as well. If your yard care business temporarily put some money in the stock market and made a killing, that's considered "extraordinary," and it doesn't count. Income must be stable and continuous and come from ordinary business activities. Of course, if your business routinely holds investments and typically earns income from them, that's different, and it's allowable.

The flip side is also true. Expenses deducted for taxes, including depreciation and depletion, are added back to your qualifying income. This means if your yard care business owns a building or depreciable equipment, your depreciation deduction gets added back when your qualifying income is calculated. In addition, extraordinary expenses (for example, an employee embezzled money one year) may be added back into your qualifying income at the discretion of the underwriter.

What about amending your tax return with less aggressive write-offs? Probably not a good idea. There is nothing in Fannie Mae, Freddie Mac or FHA guidelines that disqualifies applicants with amended tax returns but Freddie Mac says this is a red flag in its fraud-prevention instructions. In addition, lenders verify income with the IRS, and it takes the IRS about 12 weeks to process an amendment. If the returns you give the lender don't match Internal Revenue records, your loan could be held up at best or denied at worst.

For most mortgage programs, there is no absolute minimum employment requirement; you don't have to be at your current job or with your current employer a specific amount of time to qualify. Lenders just want to be sure your income is likely to be stable, and that depends on your qualifications, work history and industry. However, because of the high number of new businesses that fail each year, mortgage lenders want a bit more certainty from self-employed applicants. For this reason, you need to have been in business for at least two years to qualify under most programs.

Expenses are a major factor when determining your DTI ratio. Underwriters calculate your DTI ratio by comparing monthly obligations to gross income. The tricky part with self-employed borrowers is sometimes, expenses deducted from their taxable income also appear on their credit reports, so applicants can be hit twice for the same expense. Suppose you have a gas card for your yard care business, and the balance and payment appear on your credit report. You're deducting the cost of gas on your tax return, so it's already reducing your income, but an underwriter is likely to hit you with the payment from your credit report as well, thus impacting your DTI ratio twice.

If you're a W-2 employee and you earn a huge raise, a promotion or a better-paying new position, underwriters use your new, higher income. However, if you're self-employed and made a lot more income this year than the year before, lenders don't give you credit for all of it — they average it over the last 24 months.

In addition, you must explain an exceptionally large year-over-year increase, or underwriters may conclude the income resulted from a windfall and not from normal business activities. It's smart, therefore, to prepare explanations for revenue increases that exceed 25 percent. An underwriter may ask you to provide CPA-audited financial statements.

What if revenue declines from one year to the next? You'll have a hard time finding approval if that's the case. FHA guidelines state, "Annual earnings that are stable or increasing are acceptable, while businesses that show a significant decline in income over the analysis period are not acceptable, even if the current income and debt ratios meet FHA guidelines."

For some conventional (nongovernment) programs, decreasing income might not get you declined, but it's a tough hurdle to clear. Instead of averaging 24 months of income to qualify you, lenders use the lower year. And they really don't like approving loans with declining income, so expect them to scrutinize the industry and geographic area in which you operate. You'll have to explain what happened and why it won't affect your ability to repay a mortgage. The underwriter may ask your CPA for a letter clarifying the income changes.

If your income declined one year but then returned to normal, providing year-to-date financial statements demonstrating this (the lender may require they be audited by a CPA to be acceptable) may help you get your loan approved. That might mean supplying three or more years of tax returns to make your point. Some businesses normally have wide swings in income. For example, home developers often have huge expenses and little revenue when they begin a project, but when the homes begin selling, income rises sharply. If your business has this pattern, you may need to provide several years of tax returns and an explanation from your CPA to earn an approval.

For wage earners, savings are not complicated. As long as the amount is sufficient, all they have to do is provide copies of their account statements. However, assets for self-employed borrowers can be complicated. Lenders often want assurance that using savings to purchase property won't drain the business of operating funds. Fannie Mae's Selling Guide says, "When a borrower intends to use business assets as funds for the down payment, closing costs, and/or financial reserves, the lender must perform a business cash flow analysis to confirm that the withdrawal of funds for this transaction will not have a negative impact on the business."

It happens. You don't have to put a bag over your head or anything; just fire up plan B.

Ask
By law, any time you're declined for mortgage financing, the lender must provide a letter stating the reason within 30 days or tell you who to contact to learn that information. Base your next action on the reasons you're given.

If decreasing business income was the reason, you'll have to make a strong case to overcome it. First, ask yourself why you are not concerned about your ability to make a loan payment despite the dip in revenue. Is it because that's your normal business cycle? Because you have many months of reserves? Or because your revenue is already back on track? Pull your evidence together — new financial statements, a CPA letter, more years of tax returns — and take a shot with another lender. On the other hand, perhaps you should be concerned about your business's health.

Ask Again
Your lender may help you find an alternative. One advantage of automated underwriting systems is loan officers can run various scenarios to see if changing some of the variables in your application will get you an approval — for instance, buying a cheaper property, making a larger down payment, adding more reserves or paying off some debt. If qualifying income is the problem, you may want to do your taxes less aggressively in the future. Check with a tax accountant to learn if you should change your tax strategy.

Fix Your Credit
If your credit score is the problem, improve it. Review the credit report your lender used and make sure it's accurate. If you find errors harming your score, your lender may be able to help you fix them with the help of a "rapid re-score." Rapid re-scorers are not questionable debt settlement or credit repair providers; they are reputable companies and work only through lenders. Only items you can prove are incorrect can be removed from your credit history. Re-scorers can clear errors in a day or two and quickly re-score your credit report. However, there is a nominal cost and no guarantee your score will increase.

Try Another Lender
If your lender turns you down, but you believe that your credit, DTI and assets meet the program's guidelines, you may be the victim of a lender overlay. Although the government and its sponsored enterprises (Fannie Mae and Freddie Mac) have minimum requirements for borrowers, lenders can use stricter underwriting rule. Even though they wouldn't lose money if the loan fails, lenders work diligently to protect their FHA, Fannie Mae and Freddie Mac approval, and keeping foreclosures to a minimum is part of that.

Overlays are not deal breakers; just contact other mortgage companies, ask them about their requirements, and apply if you think you meet their guidelines.

Try a Stated-Income Loan
These are different from the riskier liar loans sold 10 years ago. You can't just mention your income today and expect lenders to believe you. Modern stated-income, doc, lite doc, low doc or Alt-A loans allow you to prove your income with alternate documentation. Instead of tax returns, lenders might look at your bank statements, for example. You need excellent credit and plenty of assets to qualify for one of these loans, and you'll probably pay a little more for it. To find stated-income loans, look for portfolio lenders, which are mortgage companies and banks that keep these loans on their own books instead of selling them through Fannie Mae or Freddie Mac.

Mortgage lenders don't turn you down to punish you. They do it when they aren't confident you can repay the loan. If your credit, income, debt or other issues can't be resolved quickly or easily, consider consulting a reputable nonprofit credit counseling service. (Avoid the shady for-profit credit repair services that spam you or advertise on late-night cable.) Reputable nonprofits can help you learn to budget, pay bills on time and save money. Stick with plan B, and you'll eventually achieve homeownership.