For the self-employed, the actual loan process is the same as for others.
You’re still going to start with a rate quote, fill out an application, sign paperwork, and you’re still going to be required to provide documentation.
Down payment, debt-to-income and credit requirements are the same, but the difference in documentation requirements is significant. While employed applicants provide W-2 forms as proof of income, self-employed borrowers will need to show their 1040 tax returns, including all schedules.
That’s where it gets tricky. Typically, self-employed tax filers write off a bunch of expenses that W-2 employees can’t and so their actual net income after all the write-offs actually is a lot lower than it would be otherwise. That makes it harder to qualify for a mortgage, because it hurts your debt-to-income ratio. The key is to show a net income, after write-offs, that meets the debt-to-income ratio that lenders prefer, usually ranging from 36% to 43%.
Because some lenders consider self-employed applicants to be higher-risk borrowers, you may pay more for your mortgage. If you’re a self-employed borrower, you have to make a decision. Are you prepared to pay a little extra for the money, in a slightly higher interest rate? With a solid payment history, you might be able to refinance at a lower rate later.
If you’re self-employed, you can make several moves to enhance your chances of getting a home loan:
- Register and license your business.
- Pay yourself a W-2 wage rather than an owner’s draw.
- Lower your debt load.
- Reduce your tax deductions.
- Keep separate business and personal accounts.
- Maintain good records using tools like QuickBooks to help track and classify income and expenses — and to generate a profit and loss statement, which lenders often require from sole proprietors.
- Consider making a larger down payment, perhaps by tapping your IRA or 401(k).
- Consider working with another small business, such as a local credit union or mortgage company where you could benefit from a factor rarely in play in lending today: a relationship.
Takeaway: If you’re self-employed, you have to acknowledge that the reality is you’re starting at a disadvantage. It’s simply part of the price you pay for calling your own shots and being your own boss!