When 32-year-old personal finance writer Eric Rosenberg was in the market to buy a home this past spring, he found that getting approved for a mortgage was far more challenging as a self-employed individual than when he had a day job.
“Even though I make more now, and I have excellent credit, the lenders were much more detailed, thorough, and strict this time around,” explains Rosenberg, who lives in Ventura, California, and runs the site Personal Profitability. “They asked for piles of paperwork and statements from CPAs that had to specifically be on the firm’s letterhead.”
Rosenberg’s challenges when securing a mortgage as a self-employed person aren’t unique.
Key Point: Freelancers’ Irregular Income Creates Lender Risk
Getting a mortgage as a freelancer can be harder than getting a mortgage with proof of stable employment.
You might have heard some of the horror stories from freelancers who are trying to buy a home. A major hurdle is that lenders may be hesitant to offer self-employed people mortgages because of their irregular income. “Loans to self-employed folks are seen as a risky bet for banks,” says tax attorney Jeff Henninger, Esq.
Key Point: Big Tax Deductions Can Hurt You at Loan Time
Another major hurdle for the self-employed is in verifying their income. “If you claim a lot of business expenses to reduce your taxable income, you could raise a big red flag with lenders,” explains Henninger. So while writing things off for taxes is a perk you enjoy when self-employed, it could serve as a disadvantage when you’re trying to buy a home.
Key Details You Need to Know if You’re a Freelancer Who Wants a Mortgage
You’ll have to provide more documentation
Because freelancer income can fluctuate, lenders are far more cautious in the underwriting process. And while it makes sense as to why lenders may be extra wary to borrowing money to a freelancer, this creates the need for some document-wrangling on your end.
While lending requirements vary depending on lender, you’ll generally need to verify your income for the past two years. Instead of W2 forms, you may need to verify your income with the following:
- Last two years of tax returns. This usually includes your Schedule C tax form, or your Schedule K-1 form if you own a partnership or your business is an S Corp. You may also need to show your business tax returns if you have a partnership, S Corp or corporation.
- Bank statements
- Year-to-date profit and loss statements
- Business license from last two years
- A verification of employment (VOE) from your CPA or tax preparer in either written or verbal form
- Letters from clients verifying you’ve worked for them
Your income is calculated differently if you’re self-employed
For those who are self-employed, lenders will calculate your average monthly income by dividing the last two years of your adjusted gross income, or net income, by 24. As lenders aren’t using your gross income, this could make your income seem less than it actually is.
This in turn lowers the amount of the mortgage for which you may qualify.
8 Critical Steps for a Freelancer to Get a Mortgage
If you’re self-employed and looking to buy a home in the near future, here’s how you can make it a less painful process:
Prepare in advance
“You have to prepare your taxes accurately and honestly regardless of whether or not you plan on trying to get a mortgage,” says Eric J. Nisall, founder of AccountLancer, a tax services company for freelancers.
To best prepare for a mortgage application, get all of your business documents, such as your profit and loss statements, organized and ready to go. “You want to show that your business is legitimate, profitable and sustainable which will make you a more attractive candidate for a loan,” adds Henninger.
Separate your business and personal expenses
If you don’t do this already, make sure that you have a separate business bank account, suggests Austin Fisher, a mortgage advisor with Finance of America. “Don’t use a personal bank account toward your business. This will help mortgage lenders track deposits and expenditures, which can help you prove the origin of business income.”
Signs that your business is making less money will have lenders running the other direction. They want to see that your business is growing and that you’re earning more money. If you can prove this, you’ll boost your odds of getting approved for a mortgage.
Save a sizable down payment
A bigger down payment makes you a less risky borrower.
Give up a few tax deductions
Henninger recommends that you consider giving up a few deductions to boost your taxable income prior to applying. With more income you may qualify for a larger loan.
Get your loan approved before house hunting
If you are self-employed, get your loan approval from the mortgage lender before you start working with an agent or shopping around for homes, suggests Rosenberg. “Getting approved for a loan first means you know your budget, what you can afford, and what’s off limits,” says Rosenberg.
Look into stated income loans
An alternative for self-employed folks who are looking for lending options are stated income loans. Stated income loans are an alternative to traditional mortgages that require the borrower to verify their income by providing detailed documentation. Instead, the borrower simply states their income and the lender takes their word for it.
This may seem too simple and good to be true. However, they do come with a few stipulations that traditional mortgages do not have. “Stated income loans require a higher down payment, more reserve assets in the bank, and, of course, the stated income must be reasonable,” points out Casey Fleming, author of The Loan Guide: How to Get the Best Possible Mortgage. You’ll need to back up your stated income with bank statements. Also, you’ll pay a higher rate than a borrower with documentation.
Credit Dos and Don’ts
Have a solid credit score. Good credit can help you get the mortgage for the amount you need and at the best rates.
Check your credit score today for free on Credit Sesame to find out where you stand.
To make sure your credit is as in good shape as possible, follow the general rules of thumb of maintaining good credit.
Don’t open new lines of credit before you’re about to apply for a mortgage. This could cause your credit score to take a dip for two reasons. The first is because each time there’s a hard inquiry to your credit, your score goes down a few points. If your score is hovering at a credit score range cutoff, those few points could make a big difference. The second reason is that a new line of credit, such as a credit card, lowers your average credit age, which also lowers your score.
Keep a low credit utilization ratio. Keep your credit utilization, which is the balance on all your cards against the total limit on all your cards, as low as possible. For instance, if the total limit on all your credit cards is $30,000, and you have a $3,000 balance, your credit utilization is 10 percent.
Pay off debt that has gone to collections. In the newest credit scoring models, unpaid collections hurt your score but paid collections don’t.
Pay all of your bills on time. Make at least the minimum payment. If you can swing it, pay more than your minimum. You can also make weekly or biweekly credit card payments.
Check your credit report for errors. You can order one free report a year from each of the three major credit bureaus—Transunion, Equifax, and Experian. The only site where you can order a free annual credit report is www.annualcreditreport.com.
Summary and conclusion
While buying a home when you’re self-employed comes with its own host of challenges, knowing where the hurdles lie and preparing well ahead of time will help you mitigate these challenges and be well on your way to buying a home.