According to the U.S. Bureau of Labor Statistics, approximately 14 million people in the United States are self-employed. These working people need to buy homes and cars just like everyone else. It’s a common misperception that self-employed people can’t get a mortgage. The truth is that they can qualify for the same loan products as traditionally employed applicants. The only difference lies in the process and criteria of qualification, since they can’t produce all the same documents as can employees.
Definition of Self-Employed
For the purpose of obtaining a loan, a self-employed person is anyone who does work not for another employer. This person may work as an independent contractor or may own a business alone or with a partner. This business may be a sole proprietorship, partnership or corporation. As long as you own 25% or more of the business, lenders will consider you to be self-employed. If you pay yourself a salary and file W-2s, you still fall into the self-employed category.
For example, you may have a W-2 job and own a small business on the side. You may not plan to use the self-employment income to qualify for a mortgage, but if you own 25% or more, you must still provide all the business information applicable. Any losses from that business will be subtracted from your W-2 income.
If you meet any of these criteria, you need to understand what is required to obtain approval for a home loan.
The Application Process
Applying for a mortgage is similar for a self-employed person as for an employee who receives regular paychecks. Both applicants must have:
- satisfactory credit history
- a stable source of income
- a down payment (if purchasing a home) that meets the requirements of the loan product for which they are applying
The difference lies in how the source of income is documented.
Both applicants generally must supply the past two years of tax returns. However, for the employed person, the tax return is used to verify that he or she has maintained stable employment with no significant changes. The determining factor for the amount of loan approval is the applicant’s paycheck stubs.
For a self-employed person, the tax returns will be used to determine the qualifying loan amount. Generally, the average of two years is used as the basis for determining income. For instance, if the person earned $50,000 the first year and $100,000 the second year, loan approval would be based on $75,000 annual income.
Another difference in the application process is that self-employed buyers must provide documentation of their business. A lender may request a Schedule K-1 if you are a partner in a partnership, or owner / shareholder in an S-Corporation.
How to Qualify for a Home Loan
If you are self-employed and looking for a home loan, start planning early. Your CPA can help ensure that you show the maximum earned income instead of taking extra deductions, which will increase your approved loan amount. Make sure your down payment funds are in your personal account instead of a business account, as buyers aren’t typically allowed to use business funds for a home loan. Also, make sure your credit score is in a favorable range.
Be prepared to provide enough documentation to satisfy the loan’s underwriting requirements. You may have to write a letter of explanation for anything that is out of the ordinary or raises a red flag. For example, a cash deposit to your bank account over $10,000 is required by regulations to be investigated. If this is a gift from a relative or an inheritance, it can easily be explained and must be documented.
There is a lot of information out there about self-employed people obtaining mortgages, but not all of it is accurate. If you have questions, talk to a trusted lender. It’s definitely possible for self-employed people to get home loans, but it’s important to understand the process and requirements to avoid unwelcome surprises.