Don't think you can get a mortgage because you are self-employed?

Dec 08, 2020

Do you want to know the number one reason why many self-employed people don't think they get get a mortgage?

They believe lenders are biased against self-employed borrowers.  To a certain degree; I think they are right!

An employee earning a regular paycheck can get fired or laid off with income going to zero in a heartbeat.  A self-employed person generally has more resources to get additional clients, restructure their business or perhaps work a few more hours to avoid losing income.  You are not going to fire yourself - right?  [Okay, I've had days when I should have definitely fired myself ... but the sevreance package was horrible.]

It's not "fair," but the lender is really qualifying you AND your company.  We can cry about it; but the better approach is to learn how to be a high quality self-employed borrower.  Here's what I've learned based on  years of lending for business owners and being self-employed for most of my adult life.

This article is the 1st in a series of three.  Warning: some of this will be pretty boring stuff to a lot of you; but it's necessary information so you can present your "Best Self" to the lender.  I strongly urge you to read through the entire series; but I'll also be sure to give you an easy summary of do's and don'ts at the end.  Okay - I know some of you will just skip to part 3 of 3, but for the rest of you ...Let's get started!

What are the typical ways a self employed person reports their income?

Sole Proprietor:  If you are not incorporated and you do not need to file a business tax return.  You will complete a Schedule C in your personal Federal Tax Return

Partnership:  This is generally a business of two or more partners.  The two most common are general and limited. The partnership files a separate business tax return and you receive either a Schedule K1 or a Form 1065 to add to your personal income tax filing.  The K1 or the 1065 will reflect your share of income from the Partnership.

Subchapter S Corporation:  Typically called an S Corp; this is a form of incorporation that appeals to a lot of sole proprietors.  It does have some tax advantages and liability protection; but is generally for a small company.  I've rarely seen more than a couple owners in a Sub S and the amount of shares is restricted.  If you are an owner in an S Corp; you'll get a Schedule K-1 to show your income from the company.

Corporation:  A full corporation  (sometimes called C Corp) is typically a much larger business with complicated structures.  You can typically get a W2 from a corporation as an employee; even if you are an owner.  Corporations pay income tax on profits; while income on the S Corp passes through to you as the owner.

Limited Liability Corporation (LLC): LLC's are somewhere between partnerships and corporations.  You can file your LLC as a partnership (with a partnership tax return) or you can treat it as a Corporation, either S Corp or full C Corporation.

IMPORTANT - for Partnership, Corporate or LLC income IF you are less than a 25% owner; your lender may NOT consider you as self-employed.

How do you show your lender what you earn?

Let's first be sure to keep in mind the lender's basic objective is to find assurance that your income is stable and consistent.  Stay with me here; you did not just see a pig fly by your window!  Reality check ...pigs don't fly and self employed folks typically don't get the same pay check every month. So how do you prove your business income is stable and consistent?  How do you prove anything to a lender?  DOCUMENTATION!

You will definitely be asked for two full years of your personal income tax returns up front. In the case of a Sole Proprietor; that is all you will need.  If you are a Partnership, S or C Corporation or LLC; you may be asked for the business tax returns.  Your lender should be able to run your loan application through their automated underwriting program with just your personal income tax returns.  I'd strongly recommend you allow them to do this before you provide any further tax returns.  Why?  Let me explain ...

Automated underwriting programs look at the entire application from how much income you have; your available cash resources (bank accounts, investments, etc.) and your credit score.  If all of those items are "golden" enough; you may be able to get by with just providing your most recent tax return and that's all.  IF you provide them with partnership and/or corporate tax returns before that decision is made; you are giving them additional information to review that they may not need.  Always remember - once a lender "sees" something; they can't "unsee" it!  Therefore, less is always more until they ask for it.

Lenders do understand that your "paychecks" may not be the same every month.  Therefore, they take a two year average of your income. (unless you lucked out with an awesome automated preapproval that only asked for one year)

Here is another reality check and one of the biggest misconceptions that I experienced during my initial consultatons with self employed clients.  Your personal income is the NET PROFIT from your business.  That means whatever money your company earns; all the expenses incurred are deducted before coming to a number you can use as income.  The harsh truth is that whatever you report to the IRS as a business expense will be considered a business expense by your lender. I'm not saying that you'd inflate your business expenses to lower your tax liabilities; but it has been known to happen on ocassion. It might be good for your tax bill; but it will hurt you when it comes time to borrowing money.  Hmmm... is this the "can't have cake and eat it too" syndrome?

There are typically two areas that you can add back to your income from deductions on your business.  Any depreciation expenses can be added back as they are not actual cash operating expenses.  If you work from a home office; any deductions you may make for that home office use can also be added back.  

What if you are a new business owner?

The standard answer used to be "Sorry Charlie."  Two years was a hard and fast rule.  It was typically two "tax years" so you could produce the mandatory income tax returns. FNMA has, however, provided a guideline that offers some hope for the newly self-employed.

FNMA is the acronymn for Federal National Mortgage Association.  They purchase mortgages from the lenders who make the loans.  Their underwriting guidelines are one of the industry standards and most conventional lenders follow their rules.

FNMA will allow a 12 month self-employed history if you can show previous experience in that field and your income is at least as much as you earned in that field before becoming self-employed.  Don't forget that your income is the NET profit from your business.  You are probably going to have to show that 12 months on an income tax return.  Depending on how your loan is approved; you might be able to provide CPA prepared income statements, but that's not typical.

How will your lender calculate your income?

The challenging piece for me to give you a solid foundation on how to calculate your income as a self-employed borrower is that the answer is often "it depends."   

First of all is the automated underwriting process I mentioned above.  The right preapproval could result in just using your last year's personal income tax return.  Sounds great?  What if last year was not so good?  You may need to look at additonal years to average in and bring it up.  You will need to assure your lender that the last year was a not typical year so they don't feel your business is experiencing consistent declining income.  You may be asked for 3 or 4 years of tax returns and a letter from your CPA explainng why last year was lower.

Let's say you did not get the "golden ticket" from automated underwriting and need to present a full two year's of income tax returns.  if that two year average of your net profit is not sufficient, and you are a partnership or corporation; you may need to provide the business tax returns.  Sometimes there are deductions on the business tax returns that can be added back to help your personal income, such as the non cash expense of depreciation.

If you are planning to purchase a home in the next couple years; my advice to you is (1) make sure your NET business profit is not understated and (2) seek the advice of your tax professional.  Here is a form that you can give to them that would be helpful.  It is Fannie Mae's Cash Flow Analysis for Small Business and is widely used by all lenders.

Conclusion

In the Pre-2008 Housing Crash; lending to self-employed borrowers was much easier.  The "stated income" loan program was initially designed for business owners who had a high credit worthiness but a challenge to document their income.  They had to meet certain credit score and cash reserves guidelines and could borrow without any income documentation.  

While the Crash quickly put an end to all of that; lenders are starting to loosen up a bit more.  While "stated income" loans are not back in the mainstream of lending; there are a few alternative programs that can use just your bank statements (business &/or personal).  Not all lenders offer these programs and I'd suggest doing a google search for "bank statement loans for self employed." 

Lending programs are always under constant change.  While it is imposible to address all scenarios of the self employed borrower is this article; I think it is safe to say that if you are prepared with the basics as mentioned above; you should be confident in seeking a mortgage.

 

Disclaimer:  I am NOT a tax professional and this article is not intended as tax advice.  If you have any questions related to the best business structure for your company; there are many online resources.  Entrepreneur has a good small business encyclopedia that I've found helpful.  And, of course, you should always contact a tax professional such as a CPA or accountant.

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