Mortgage Challenges for the Self-Employed

model house with money unde itNobody likes the mortgage application process. It can particularly seem like walking through a financial minefield if you are self-employed or a small business owner.

The basic requirements about income and debt ratios are the same, but proving your qualification to a lender’s satisfaction can be tricky to do.

Mortgage lenders prefer the type of documentation that an employee with a solid employment record can provide: YTD paystubs, easily documented W-2 earnings, 2 years of steady and increasing income shown on tax returns and built-in assumptions about the probability of continued employment. This can be a bit problematic for self-employed individuals.

How is Self-Employent Defined?

One surprise that many borrowers face is the definition of being self-employed.

You may be startled to learn that you can have employees and even use an LLC or corporation for business operations and still be self-employed for mortgage application purposes. Having other owners in the LLC or corporation doesn’t insulate you from being defined as self-employed.

Here’s the deal. If you own 25% or more of a business, you are a self-employed mortgage applicant. Not only will you need your personal tax returns, but you will also need to provide two years of your business’ tax returns and a year to date (YTD) Profit & Loss Statement (P & L) for your business.

How Does the Lender Calculate Self-Employment Income?

Income for self-employed individuals can vary substantially from year to year & isn’t always steady from month to month, either.

Depending on the state of one’s business, substantial portions of income can come in early or later in a year and be flat-lined in other months. Even if it works out by the end of the year, if you are applying during a lean period it won’t be easy to prove your income to a bank’s satisfaction.

For self-employed individuals, banks use an average of the last two years of income shown on your tax returns. They also want to see proof of an equivalent income for your current business year.

So even if you have had steady income in the past and have a good credit rating, if you have a bad business year or are in a lean period of months, it can work against you. Conversely, if you’re having a great year now but one of the prior years was less robust financially, they’ll most likely discount your current earnings because of the averaging of past returns.

So what can you do to improve your chances?

Document and report all your income. Being too aggressive with deductions or not reporting income for tax purposes can not only get you into serious trouble with the IRS, but it also will be detrimental for your mortgage application.

Keep excellent documentation, as you’ll need:

  • Two to three months of bank statements
  • Two years of personal tax returns
  • Two years of business tax returns
  • One year of cancelled rent checks if you are renting
  • Current statements for all asset accounts – money market accounts, stocks, CDs, mutual funds, IRAs, etc.
  • Proof that your down-payment is coming from your own assets, not from a loan.

Consider using a CPA to do your taxes because Lenders are apt to be more comfortable with tax returns prepared by an outside firm.

Lenders typically ask for statements from your CPA about the current state of your business or your YTD income to document what you have told them.

Surviving the Process

The key to getting through this successfully is accepting that you will be providing a lot of documentation and that it is your job to prove the facts. In the current mortgage market, lenders do not take your word for financial items – you need to be able to show them the money to their satisfaction.

And bear in mind that patience is definitely a virtue in this process.