Self-employment comes with perks: freedom, flexibility, creativity and the ability to essentially set your own income. But it also comes with challenges, especially as you try to reach traditional financial and life milestones like buying a house.
I know. When I bought a house in 2007, I faced a few extra hurdles because I was using my self-employed income to qualify for a mortgage. In the end, I managed to qualify for a mortgage with a good rate, but I had to clear some obstacles first.
1. Prove your business is profitable.
“When you’re self-employed, you do your best to reduce your taxable income,” said Casey Fleming, a 30-year veteran of the California mortgage industry and author of The Loan Guide. “Without W-2s and regular pay stubs to prove your income, lenders look at your tax returns, which can make it look like your debt-to-income ratio is too high.”
Generally, lenders consider the past two years of tax returns. With my freelancing business just ramping up for a third year, the previous two tax returns showed a small amount of income — especially since I was deducting everything I possibly could.
To prove my increasing income, I agreed to an audit, handing over six months’ worth of bank statements so an accountant could comb through them. But I soon found out that wasn’t enough for me to show an increase in income.
2. Prove your self-employed income is stable.
With my income audit underway, proving that the revenues from my business were sufficient for a mortgage, I thought the home loan was in the bag. But pretty soon, I got a call from the accountant. My income audit wasn’t just about looking over bank statements. The accountant needed details about my clients, how often they paid, and the regularity of the work.
“Lenders look for stability when they approve a mortgage,” said Fleming. “Many self-employed people have income that fluctuates month to month. You’ve got to show that there’s a reasonable expectation that you’ll at least be able to meet your obligations, even on a bad month.”
To get through my income audit, I provided the accountant with contact information for my regular clients. I also went through my bank statements with the accountant, highlighting deposits and noting which clients paid them. For supplemental information, I provided PayPal statements so the accountant could match those transactions with bank deposits.
Finally, the accountant called a few of my clients to verify the work I did for them and to confirm that we had long-term contracts that would supply me with a degree of income stability.
The process added two extra weeks to the mortgage approval process — and I had to pay the accountant for his time.
3. Prove you have extra money in the bank.
You don’t have to go through an income audit to get a self-employed mortgage, according to Fleming. It’s still possible to get a mortgage even with a lower degree of documentation. However, if you go this route, you might need a bigger down payment.
I was able to get a Federal Housing Administration loan with the minimum down payment requirement because I was willing to go through an income audit. But while shopping around, I found lenders willing to qualify me for a low interest rate without that vigorous income documentation — I just needed to come up with a full 20 percent down payment.
“Lenders are loosening their standards a bit again,” said Fleming. “If you can make a big down payment and show reserve cash in the bank, some lenders are willing to make loans on the strength of your bank statements and stated income without the need to go through a full-blown audit.”
However, depending on your situation, a lower level of documentation could mean a slightly higher interest rate, Fleming said. “It’s not going to be a huge increase, maybe a point or so, but you still might end up paying a bit more in interest.”
Alternative Home Loans For The Self-Employed
No matter your situation, “regular” criteria for getting a mortgage apply to the self-employed: good credit, a low debt-to-income ratio and other well-known factors.
“The main difference when you’re self-employed is that you’ve got to come with ways, other than your pay stubs, to show that you can handle your payments,” said Fleming.
But what if you don’t have good credit or meet other important standards for getting a mortgage? Fleming says that, in those cases, you can go to nontraditional lenders. These lenders might be willing to overlook credit indiscretions if you have a much bigger down payment, maybe even up to 60 percent. Additionally, you can expect to pay much higher interest rates.
“In many cases, as with anyone else getting a home loan, it’s a good idea to get your credit in order and make sure you can prove your income,” says Fleming. “If you prepare ahead of time, there’s no reason why you can’t get a mortgage when you’re self-employed.”