Many people have a dream of working for themselves. But when it comes to buying a home, self employment can put a damper on those high hopes. Here are some things to consider when seeking a loan so your borrowing attempt never becomes nightmarish.
Self-employed mortgages vs. regular loans
When you are applying for a mortgage, usually the lender will focus on your financial history over the past two years as well as your credit score. They will look at W-2s or paycheck stubs, and inquire about your bank balances and other outstanding debts.
If you are self-employed, it’s not much different. However, you won’t have those W-2s or paycheck stubs. The lender, concerned with your financial stability and the financial health of your business, will need other means to assess the risk of lending to you.
The lender will be checking two sets of documents: your personal financial records, as well as your business records. That’s why it’s important to keep rigorous records of your income and to report them accurately when you file taxes.
You’ll need to supply your personal income tax returns for the past two years. If your company is incorporated, you’ll also need to supply two years of income tax returns for the business. The lender will often also request a current balance sheet for the business, as well as a current profit and loss statement. The lender will check the credit rating of your business, as well as your personal credit rating. Both will be considered in approving the loan.
The documentation you’ll need to furnish, and the way it’s viewed by the lender, depends on the structure of your business:
Your taxable income (or net income) is considered your total revenue (or total income) minus expenses. The sole proprietor category can be used even if your business is an LLC (limited liability corporation).
The lender will need to see your corporate tax returns for the past two years, as well as your personal tax returns. This category can apply to fully incorporated businesses or to an LLC.
If your company is a partnership, the lender may ask for two years of tax returns from the business.
Borrowers need to understand that for a long time now, self-employed people, company directors, freelancers and people on bonuses have found it difficult to get finance for their home on a mortgage. That’s partly because the self employed often minimize their reported income to lower their tax obligation. Traditionally, a bank or building society will only lend you 3.5 times your earnings, thus limiting the borrowable amount for this category of homebuyer.
Securing a mortgage, or refinancing, is possible for self-employed borrowers. (Photo/Pixabay)
Understanding the self-employed refinance mortgage
The self employed have similar challenges when it comes to refinancing one’s mortgage, too. Since it’s harder to refinance with only self-employment income, what your credit report says is going to make a huge difference.
Just having declared income in non-traditional ways can impact the risk associated with you as a borrower, thus driving up your interest rates. And if you have a poor financial history or debt payment record, being self-employed could mean not being able to get a loan at all. You can combat these challenges by regularly keeping track of your credit score and making sure your credit record is accurate. Small errors could mean the difference between a good credit score (like 720) versus a riskier one.
Your other tool for solving the self-employment bias is to know the equity of your home if you already are a homeowner. Even when you carry debt on the home (your mortgage balance), you could have a substantial amount of equity that could be tapped. Cash-out refinancing and HELOC (home equity lines of credit) loans are ways you can get ahead financially, whether or not you are self employed.
The question of income for the self employed
In most cases, the biggest challenge for home refinancing for the self employed is income. Refinancing for self-employed homeowners works the best when the most income is claimed. This opens up better rates and qualifies the self-employed business owner for higher loan limits.
However, most refinance loans for self-employed homeowners use the 1040 form’s taxable income after deductions as the income level. Of course, self-employed people are going to write off as much as they can, which often reduces their reported income to levels much lower than what they are actually are. This creates quite the conundrum.
For the best terms and rates, a self-employed person should have at least two years of verifiable self-employed income. If this is not available, it’s possible to “declare” income using things like a profit and loss statement. But these loopholes are getting more difficult to utilize as lending regulations have gotten stricter in recent years.
The bottom line is that if a homeowner knows they are planning to delve into some kind of mortgage refinancing when they are self-employed, it can make sense to take a tax hit. You may pay more in taxes for a couple of years, but your new 10 to 30-year mortgage will be easier to get and come with significantly lower rates. That could spell big savings over the long haul.
The value of appraisal when refinancing and self-employed
One final note should be considered for anybody seriously working toward a self-employed refinance loan. Most banks will require that the home be appraised again to determine value and equity.
If the market has been booming, this could result in more value in the home. And that’s excellent, especially for someone looking to do a cash-out refi. However, if things are on a downward trend, you may want to wait on doing the appraisal. That’s because your lender could have a harder time underwriting the loan amount you desire, as the industry has restrictions on how much it can loan out compared to overall value of the home.
If being self-employed is your goal, then don’t let the mortgage and refinancing challenges deter you. Just know from the start, that excellent record keeping, strong credit scores, and accurate reporting of your income will go a long way in delivering the mortgage or refi of your dreams.