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Self-employed Mortgage

Formerly, self-employed homebuyers come with restricted guidelines. Lending companies have finally loosened up these guidelines for accessing financial aid.

The newly imposed guidelines make it much easier for self-employed mortgage borrowers. Just like the traditionally employed borrowers, self-employed mortgage will hold you to the same standards for credit, debt, down payment, and income.

Documenting your income to prove cash flow may be tough and can require more paperwork. But this should not stop you from buying a home or refinancing as long as you meet loan guidelines.  

For instance, you will only be required to provide a year of income tax documents to prove your income sufficiency – only if your application is accepted for automated underwriting.

Additionally, lenders use a separate and new calculating system for business owners who are lacking sufficient distribution history. People who are trying to qualify with income from side jobs do not need the documentation if they are using their regular day job.

Rules of Self-employed Mortgage

At least two years of steady self-employment is required to most mortgage lenders before qualifying for a home loan. Self-employed, as defined by lenders, has an ownership interest of 25% or more in a business, or one who is not a W-2 employee.

However, since the guidelines have finally loosened up, there are exceptions to the two-year rule.

Once year of self-employment might possibly get you qualified when you can show a two-year history in a similar line of work. You will be needing a documentation of an equal or greater income in the new role compared to the W-2 position.

Other lenders would even consider one year of related employment plus one year of formal education or training as an acceptable work history.

Being self-employed for less than a year would most likely disqualify you for a home loan.

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Standard Loan Program Requirements

Apart from the employment history, self-employed mortgage requires borrowers to meet the standard loan program requirements.

While guidelines may vary depending on the type of loan, expect that a lender will scrutinize the following criteria:

  • Credit score
  • Credit history
  • Current debts (for computing debt-to-income ratio)
  • Liquid savings and assets (to compute for the down payment and closing costs)

The type of property and its intended purpose will have an impact towards the type of mortgage loan you can qualify for as well as your interest rate.

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Qualified Types of Income

Generally, mortgage lenders consider any source of income as long as it’s stable, consistent, and ongoing. This includes but not limited to the kind of self-employment:

  • Freelance income
  • Contract work
  • Seasonal work
  • Gig work / side jobs
  • Business owners

The abovementioned sources can be considered on their own, or as additional funds on top of a primary income source.

Unemployment income for contract or seasonal workers are sometimes counted as long as they have a regular, documented history of receiving unemployment in the off-season.

An income that is ongoing must be determined by the lender for any source of income. It generally means that the income is likely to be ongoing for at least 3 years after closing. Business prospects need to be in the good condition, and a history of declining income will not make a chance.

Self-employed borrowers may be reviewed by the lender to determine its stability and the likelihood their income can continue at the same level.

However, you could have a serious problem if your industry seems to be declining especially during the coronavirus pandemic.

Lenders Only Consider Taxable Income

Lenders can only count taxable income toward your mortgage. Self-employed applicants may see this as a major obstacle in seeking financial aid. For instance, they could say they are making $6,000 monthly whereas it’s actually $4,000 only for the taxable income.

Underwriters use a particular formula to come up with a “qualifying” income. Starting with your taxable income, they add back certain deductions such as depreciation. Depreciation is not considered an actual expense coming out of your bank account.

Self-employed workers and business owners often take money deductions as possible. However, this can also hurt your mortgage application. Self-employed borrowers use a type of mortgage called a bank statement loan. It lets you qualify based on the incoming total funds instead of tax returns. But bank statement loans are considered non-qualified (NQ) mortgages. The downside is that they lack some of the consumer protections of major loan programs and higher interest rates.

Even with a smaller loan amount, most of the self-employed mortgage borrowers still stick to the mainstream loan programs with lower interest rates.

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How Self-employed Income Is Calculated

Self-employed income for a mortgage is typically calculated by getting the average of your income over the past two years and break it down by month.

Let’s say your tax returns for the past two years show an income of $65,000 and $75,000. Your monthly income for qualifying purposes will be calculated this way.

YEAR ONE: $65,000

YEAR TWO: $75,000

AVERAGE YEARLY INCOME: $70,000 ($65,000 + $75,000 / 12)

MONTHLY INCOME: $5,830 ($70,000 / 12)

The lenders have calculated that $5,830 can be spent on housing and other expenses, monthly.

Income Inconsistency

Almost any lender requires self-employed mortgage borrowers to have consistent, stable, and ongoing income. Generally, an irregular and unreliable income won’t count.

However, businesses could go through ups and downs. A home developer could be starting a new community with lots of expenses for a year. From property buying to pulling permits and constructing houses. The business therefore may show proof of small income or even big losses.

Applying for a loan during the ‘down’ year might be tougher. You will be asked by your lender to provide a proof of healthy and stable business. A documentation of more than two years’ worth of tax returns, three-five years of tax forms to the underwriters, and a statement from your CPA.

Preparing for an explanation to a significant year-over-year decrease in income would also help.

Self-employed 'Side' Income

If you are a W-2 employee but you have a side gig or freelance job for some extra income, you might not have to report self-employment income to your lender.

As for the conventional loans, Fannie Mae & Freddie Mac suggest that self-employed income does not need to be reported if it is not used to qualify for the mortgage. The lender ignores self-employment income and not ask you to document it if W-2 income and personal savings alone can be used in order to qualify.

These guidelines apply to self-mortgage borrowers living off retirement income, social security income, pension payments, and/or dividends too.

Remember that guidelines for other loans may be different. The said rules apply to conforming (Fannie Mae & Freddie Mac) home loans.

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Self-employed Mortgage Loan Options

All the mortgage programs are available to be used by self-employed borrowers. It includes conforming loans (those backed by Fannie Mae & Freddie Mac) and government-backed FHA, VA, and USDA loans.

Conventional Loans for Self-employed

This is the type of mortgage that is eligible for purchase by Fannie Mae or Freddie Mac.

Fannie Mae and Freddie Mac qualify self-employed borrowers with after at least two years of self-employment. Borrowers with at least a year of self-employment are also qualified, but they need to provide a documented history of at least two years earning comparable income in a comparable role.

Conventional loans/conforming loans also require:

  • Credit score of 620
  • Minimum down payment of 3%
  • DTI ratio below 45%
  • Loan amount within forming loan limits

Conventional mortgage is ideal for borrowers with good credit and a moderate to large down payment (10% – 20%).

Self-mortgage borrowers can avoid private mortgage insurance (PMI) if they can put at least 20% down.

FHA Loans for Self-employed

This type of loan is ideal for borrowers with low-credit and/or first-time home buyers having more lenient requirements.

FHA loans require:

  • Credit score of 580
  • Down payment of 3.5%
  • DTI ratio below 50%
  • Planning to occupy the property as primary residence
  • Loan amount within current FHA loan limits

FHA also requires self-employed borrowers a two-year self-employment history. Alternatively, one year of self-employment plus two years in a related role with similar income. If you have a year in a similar role and a year of formal training or education, FHA can consider this as an acceptable two-year history.

Typically, FHA requires 2 years of personal and business tax returns to document self-employment income.

Business tax returns are no longer required when:

  • Personal returns show an increasing income over the past two years.
  • Down payment and closing costs are not coming from the business account
  • The loan is not a cash-out refinance

VA Loans for Self-employed

VA loans have ultra-low interest rates and no ongoing mortgage insurance. Requirements are fairly lenient as well. At least 2 years in your current role, or one year of self-employment plus a two-year related work history.

VA loans require:

  • Credit score of 580-620
  • 0% down payment
  • Eligible service history

USDA Loans for Self-employed

As guaranteed by the U.S Department of Agriculture, this loan does not require any down payment and have below-market rates.

At least owning low-to-moderate income and residing in a qualified rural area to get qualified for USDA financing. Lenders will also require a two-year history in their current role, or at least a year of self-employment and two prior years in a related role.

USDA loans require:

  • Credit score of 640 or higher
  • 0% down payment
  • Income not higher than 15% above the area median
  • Property is a single-family residence
  • A 30-year, fixed-rate mortgage must be in use

Restrictive as it may sound, majority of the U.S landmass qualifies as ‘rural’ under USDA’s definition. Therefore, it is working asking the lender whether you are among the qualified borrowers.

Self-employed Co-borrowers

Most of the lenders approve the self-mortgage application with a co-borrower provided that one is traditionally employed while the other is self-employed. Self-employment income must meet the abovementioned guidelines and both applicants must also meet the loan requirements.

You can have a choice whether you will count your co-borrower’s income or not.

Qualifying for a loan with your own income with your co-borrower as self-employed, it means that your lenders can disregard that in the underwriting. But how come this is a good thing? Because many of these small business endeavors and some of the more mature startups do not show any income on tax returns. At least on paper, they generate losses.

This could look bad when you are seeking financial aid, but a good thing for trimming down what you owe in taxes.

Alternatives For Self-employed Mortgage Applications

Many self-employed mortgage borrowers cannot show enough income which results to declined application. However, there are still alternative programs called bank statement programs that allow you to count all of the business cash flow as income.

Bank statement programs require you to bring in 12 or 24 months of your bank statements – business and/or personal bank statements would be acceptable. These statements will then be analyzed by your lenders. The monthly cash going in will be checked, averaged, the used to come up with a qualifying income.

Unfortunately, these programs typically come with higher mortgage rates compared to mainstream loans. Also, they are considered riskier since they are non-qualifying mortgage.

Conclusion

Qualifying for a self-employed mortgage is not as difficult as you think. Like the traditionally employed individuals, self-employed borrowers have access to the same mortgage programs and the same low rates as other borrowers.

Make sure to shop around and compare offers in order to get the best rates and term possible.