Homeownership for the Self-Employed© | by Jeremiah Flowers

Mortgage rules have undergone numerous changes since the housing collapse to ensure that only qualified buyers have access to loans. Meeting certain lenders' requirements can be particularly difficult if you're self-employed. If you're one of the nearly 15 million self-employed Americans and you're hoping to buy a home this year, here's what you'll need to keep in mind.

Documentation Can Make and/or Break Your Loan Approval…

When you punch a clock at a regular job, mortgage lenders use pay stubs and direct deposit slips to verify that you have a steady source of income. When you're self-employed, proving that you're making enough money to buy a house can be tricky. Generally, when you're self-employed, banks want to see tax returns from the past two years. They then average your income for both years and come up with a number that represents how much you're making from month to month. That's the number they'll use to calculate your debt-to income-ratio during the application process. It's important to keep track of how much money you're earning so that you can present that information to your mortgage lender. Your lender's going to want to make sure that you have enough cash to buy a home. If you receive a large check as a payment from a client, it's a good idea to get a copy of the deposit slip from your bank to show where that money came from. You'll also need to be able to prove that you are, in fact, running a business and not making money from a hobby. This can be fairly easy if you're operating a business that requires you to have a license. If you're an independent contractor, on the other hand, you might need to have receipts from your clients in addition to tax forms and bank statements to show that you've been in business for at least two years.

Taking Large Deductions Can Work Against You

When you own a business, you're responsible for paying both self-employment tax and income tax on what you make. One of the ways you can offset the size of your tax bill is by deducting certain business-related expenses. But those tax deductions can prevent you from qualifying for a mortgage if they substantially lower your taxable income. When you're making $75,000 a year but writing off $30,000 in expenses, for instance, that can reduce how much house you can afford from a lender's perspective. If you have paperwork to prove that your income was lower because of a large, one-time deduction such as an equipment purchase that could bolster your chances of getting approved for a mortgage.

Get Your Taxes Done By a Pro

Aside from looking at the numbers on your tax returns, mortgage lenders also concern themselves with who prepares your taxes. If you're doing your own taxes at home with a tax software program (like TurboTax or Credit Karma), that could raise an eyebrow as to whether the numbers you're reporting are legit. Having your taxes done by a CPA or another tax professional can be reassuring to a lender who's concerned about the accuracy of your returns.

The Bottom Line

Being self-employed isn't a deal breaker if you're trying to buy a home. But owning your own business or operating as an independent contractor can make the home-buying process more challenging. Talking to a lender before you apply for a loan can give you insight into the kinds of hoops you'll be expected to jump through and how likely you are to be approved for a mortgage. You might also consider talking to a financial advisor about how buying a home will factor into your overall financial plan. You want to ensure that you can purchase a home without sacrificing your other financial goals. Guidelines for self-employed home buyers have loosened up. For example, you may only need one year of income tax documents to prove your income, as long as your application qualifies for automated underwriting. Plus, lenders are using a new income calculation for business owners with little or no history of distributions. The new loan guidelines are also more friendly toward "moonlighters." Those with self-employed side gigs don't always have to document this income if they qualify using only their day job.

Mortgage approval for self-employed applicants

When you're buying a home or refinancing, you go through a set of specific steps. First, you apply for your loan, which you can do in-person, online, or by telephone. In most cases, the loan officer or processor takes your information verbally and submits it into an automated underwriting system (AUS). You don't usually have to fill out a bunch of forms yourself. 

You'll need to document your income, savings/retirement/investment balances, and your debts. Lenders want your employment history, and they will check your credit.

Underwriting self-employed borrowers

Based on your information, the underwriting system generates a response in minutes, either approving, declining, or referring your loan for human underwriting. Then, the human underwriter takes over. If the AUS approves you, the underwriter checks your documents to make sure that they match the information on your application. For instance, if you said that you earn $6,000 a month, your W-2s or tax returns should match that. your bank statements should match what you say you have. If the system can't make a decision or declines your loan, a human takes a second look to see if you qualify under manual underwriting guidelines.

Lenders only consider taxable income

Frequently, what trips up self-employed applicants is that they might say they earn $6,000 a month, but their taxable income might only be $4,000 a month. Underwriters use a somewhat complicated form to come up with "qualifying" income for self-employed borrowers. They start with your taxable income, and add back certain deductions like depreciation, since that is not an actual expense that comes out of your bank account. But they might subtract "extraordinary" or "windfall" income. If a source of income does not appear to be stable and ongoing, you can't usually use it to qualify for a home loan.

Other documents

Lenders also look at your assets, to make sure that the down payment comes from an acceptable source. They don't want to see you clean out your business account to make your down payment, for instance, because that could put your livelihood in jeopardy. And they want to make sure that you do not have undisclosed loans. For example, if your bank accounts show an unusually large deposit made within the last 60 days, your underwriter may ask you to prove the source of that money. You may have to provide other documentation too, at the underwriter's discretion — a business license, for example, or a statement from your accountant.

Credit approval

Once the human underwriter gives you the green light, you have credit approval, which means that you, the borrower, meet the lender's guidelines and can close as long as the property also complies with the lender's requirements. However, the underwriting process varies from applicant-to-applicant and loan-to-loan. Underwriters can require different documents for every self-employed mortgage borrower.

How long must you be self-employed to get a mortgage?

You may not have to show a 24-month self-employment history to get a mortgage. For instance, Fannie Mae says that you may qualify with 12 months of self-employment if you have previous experience in that field, and your income is at least as much as you earned in that field before becoming self-employed.

Mortgages for self-employed borrowers

Since late-August 2015, Fannie Mae allows a looser set of guidelines for the nation's self-employed borrowers. The policy updates encompass three areas :

*Self-employed borrowers with no history of "taking paychecks" (i.e. business distributions are irregular or non-existent)

*Self-employed borrowers who don't have two years of federal tax returns to support their business

*Salaried borrowers with second, self-employment jobs don't need to document that income if they don't need it to qualify for their mortgage

Proving business income

For self-employed borrowers with a history of paying themselves, mortgage guidelines as of June 2016 state that the borrower no longer needs to prove access to the business income. The applicant, however, may still need to show that the business earns enough to support income withdrawals.

One year of tax returns

Self-employed borrowers may qualify with just one year of tax returns. Those returns must show at least 12 months of self-employment income. And the applicant's debt-to-income ratio must meet lender guidelines (usually a maximum of 43 percent, but it can go to 50 percent for exceptionally-qualified borrowers.

Self-employed "side" income

It's the third provision which may be most welcome to self-employed mortgage borrowers — especially those who don't rely on their "side business" to support their home or household. Under Fannie Mae's new rules, borrowers qualifying for a mortgage using the income of their "regular" job don't have to prove what they make on the side from their business. Which makes sense; if you don't need the income to qualify, why would you have to prove what it is? This provision applies to borrowers living off retirement income, social security income, pension payments, and/or dividends as well. Note that these rules apply to conforming (Fannie Mae and Freddie Mac) home loans. Guidelines for other loans may be different.

Self-employed co-borrowers

Similarly, if you qualify for a loan with your own income, and your co-borrower is self-employed, lenders can ignore that business in underwriting. Why would you want them to ignore that business? Because many small ventures, or even larger start-ups, don't show income on tax returns. At least on paper, they generate losses. While these business write-offs are great for reducing taxes, they can murder your qualifying (taxable) income when you apply for home financing.

Income inconsistency

Almost every lending guideline specifies that income does not count unless it is "stable, consistent, and ongoing." If your income is not regular and reliable, you can't use it. However, many businesses go through ups and downs. For instance, a home developer starting a new community might have a lot of expenses one year, buying property, pulling permits and constructing houses. The business may show little income or even big losses. The next year, though, the houses sell and the income soars. If you apply for a loan during the "down" year, you'll have to prove to the lender that your business is healthy and that this is a normal pattern. Give the underwriters, three, four or five years of taxes and a statement from your accountant to show this. Prepare to explain any significant year-over-year decrease in income when you apply for a mortgage as a self-employed borrower.

Alternatives for self-employed applicants

Self-employed mortgage loans have gained a reputation of being difficult since the housing downturn. That's because many self-employed borrowers don't show enough income, if the lender's definition of "income" is the bottom line on your tax return. And the old "stated income" or "no income verification" loans these borrowers used in the past have disappeared. Self-employed borrowers write off as many expenses as legally possible. That's reasonable, because they pay self-employment taxes in addition to "regular" income tax. However, alternative programs allow you to count all of your business cash flow (the amount you actually bring in) as income. These are often called "bank statement" programs. Under these guidelines, you bring in 24 months of your business and / or personal bank statements. Lenders analyze the amounts going in each month, average it, and use that amount (or some formula based on that amount) to come up with qualifying income. Note that these programs usually come with higher mortgage rates

Personal loans

One option for self-employed borrowers could be a personal loan. A personal loan may be easier to qualify for than a mortgage. If you are looking to cash-out your home via a refinance, a personal loan might be the easier route. If you're looking to buy, a personal loan might be a stretch, unless you are purchasing a sub-$100,000 property, since that's the typical max for these loans. In any case, if you need quick cash or your business needs a cash infusion (whether or not you're getting a mortgage), a personal loan might be the jolt your company needs to shoot to the next level.

Planning ahead

If you're self-employed and want to buy a home, plan in advance. Work with a mortgage professional, and involve your accountant as well. You can change the way you write off your business expenses, and the amount of taxable income you show. Alternatively, you can amend previous tax returns to show higher income from the past. Note that some deductions, such as depreciation, won't hurt you. Underwriters add these deductions back into your taxable income. You and your accountant can check out the form underwriters use, and see how lenders will view your income right now.

Stay aware. Ask questions. Know the difference. 

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