Love being your own boss? Unfortunately, you might not love the process of applying for a mortgage when you’re self-employed.
Of course, you won’t be alone: The Bureau of Labor Statistics projects the number of self-employed workers in the U.S. will climb to 10.3 million by 2026, up from 9.6 million in 2016. Nonetheless, this growing group faces a few extra obstacles attaining a mortgage over full-time employees who receive a W-2.
The good news? By knowing what mistakes typically trip up these freelancers and business owners, you can avoid a ton of home loan hurdles and headaches. Here are three problems to watch out for if you hope to finance a home purchase soon.
1. Your income is high, but erratic
As they do with typical home buyers, lenders will check to see if your income is high enough to pay for the mortgage. Self-employed borrowers, however, must also show that that income is fairly steady without wild fluctuations that might cramp their ability to pay a monthly mortgage, says Todd Sheinin, lender and chief operating officer at New America Financial, in Gaithersburg, MD.
To prove the stability and viability of your business, you’ll have to provide at least two years’ worth of federal tax returns. (If you’re newly self-employed, some lenders will accept only one year of self-employment tax returns if you can also provide W-2s from an employer in the same field and your current income is at least as much as you earned from your previous employer.) Though some income fluctuation is acceptable, your business should be making steady or increasing revenue each year.
To validate your business income, many lenders will also require you to provide a profit and loss statement, or a 1099 form. The caveat? If your business carries debt and you pay those debts out of a personal checking account or charge them to personal credit cards, the business debt is going to negatively affect your debt-to-income ratio qualifications. The DTI ratio is what you owe in obligations like credit card payments, student loans, car loans, installment loans, car loans, personal debts, alimony, or child support, divided by your monthly income.
As a general rule, if you want to qualify for a mortgage, your DTI ratio cannot exceed 36% of your gross monthly income, says David Feldberg, broker/owner of Coastal Real Estate Group, in Newport Beach, CA. For example, let’s say you’re paying $500 to debts and pulling in $6,000 in taxable income. Divide $500 by $6,000, and you get a DTI ratio of 0.083, or 8.3%.
However, that’s your DTI ratio without a monthly mortgage payment. If you factor in a monthly mortgage payment of, say, $1,000, your DTI ratio increases to 25%. A higher DTI ratio could mean you’ll pay a higher interest rate, or you could be denied a mortgage altogether.
The challenge for self-employed workers is that mortgage lenders will consider only their taxable income when assessing their DTI ratio. (For W-2 employees, their pretax earnings are used.) So, if your company makes $5,000 a month in gross revenue, your taxable income might be only $4,000 if, say, your company has $1,000 in work expenses.
2. You mix business with pleasure on your credit cards
Like other borrowers, you’ll need a strong credit score to qualify for a conventional loan when you’re self-employed. Though a perfect credit score is 850, all scores above 759 are considered to be in the best credit score range, since this means you’ve shown an excellent ability to pay off your past debts.
Borrowers with outstanding credit qualify for the lowest interest rates, says Richard Redmond, author of “Mortgages: The Insider’s Guide.”
But know this: Using personal credit cards to pay for business expenses can hurt your credit score if you’re carrying a large balance from month to month, or you’re missing payments. Even just one missed payment can cause as much as a 90- to 110-point drop in your score, according FICO, creator of the widely used FICO credit score.
The moral of the story: “Don’t mix business expenses with personal ones,” Sheinin advises.
Not sure what your credit score is? You can check your score for free at CreditKarma.com or perhaps with your credit card company, since some (like Discover and Capital One) offer free access to scores and reports. You’re also entitled to a free copy of your full credit report at AnnualCreditReport.com.
3. You don’t have all your paperwork straight
In addition to requesting documents that show proof of your income, lenders will also be looking at your savings, financial assets, and monthly debt obligations “to make sure that you have the means to take on a mortgage comfortably,” according to Freddie Mac, a government-sponsored enterprise that helps thousands of Americans get home loans.
Here’s the paperwork you’ll have to provide:
- A quarterly statement, or statements for the past 60 days, of all of your asset accounts, which include your checking and savings, as well as any investment accounts (e.g., CDs, IRAs, and other stocks or bonds)
- Any other current real estate holdings
- Residential history for the past two years, including landlord contact information if you rented
- Proof of funds (e.g., bank account statement) for the down payment (If the cash is a gift from your parents, you need to provide a letter that clearly states the money is a gift and not a loan.)
Keeping up-to-date records of your business accounts is crucial, but having a tax preparer review these documents before you submit them to mortgage lenders can help you spot any inaccuracies. That could make the difference between getting approved or rejected for a mortgage, since “even small mistakes can hurt your application,” Sheinin says.
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