Does it seem like the mortgage process was designed for traditional W-2 employees? Well, that’s because it sort of … is. But if you don’t have paycheck stubs because you work as a freelancer, or if your income and work history vary wildly, don’t sweat it. Self-employed people can qualify for mortgages too.
Here are six ways self-employed people can help themselves qualify for the biggest loan they’ll ever need — the one that buys a house.
1. Look at your past two tax returns
How do most lenders calculate your monthly income? First, they’ll ask for copies of your tax returns from the past two years. Next, they’ll look at your adjusted gross income on each form, add the two numbers together, and divide by 24. This reflects your average monthly income from the past two years.
The lender will base its decision on whether to approve your loan application in part from this monthly income figure. It’s a simple equation, so if you want to get an idea of how large a loan you’ll qualify for, crunch the numbers yourself using one of Trulia’s mortgage calculators.
If you consistently operate your business at a loss, taking advantage of every write-off possible, you may want to focus on moving from red to black so that you can prove you make enough money to pay a mortgage.
2. Complete the paperwork
Once upon a time (cough: in the 1990s), you might have been able to supply bank statements to your mortgage lender to prove your business cash flow was healthy enough to support monthly mortgage payments.
Those days are gone.
Lenders now will insist on looking at your tax forms, and they’ll need to collect this from the IRS directly. (After all, you could theoretically supply them with a form filled in with made-up numbers.)
To expedite the process, you’ll need to fill out IRS Form 4506-T, which gives the lender permission to request your tax records from the IRS. As long as you’ve been honest with the taxman, there’s no reason to be concerned about revealing your financials.
3. Debt-to-income ratio
By now you probably know that your mortgage qualification will be based on your income and your creditworthiness. But how exactly does income play a role in your application?
Most lenders will allow you to borrow only a specific percentage of your income. This is called a “debt-to-income” ratio (DTI) and lenders will be on the lookout for two numbers:
- Front-end: Your housing-related debt payments shouldn’t exceed 28% of your income.
- Back-end: Your total recurring debt payments (including housing, student loans, credit cards, car loans, child support, alimony, and more) shouldn’t exceed 36% of your income.
How can you qualify for the best mortgage possible? Reduce or eliminate your other debt payments, such as your car note or credit debts owed. This will improve your back-end DTI ratio, which will help you qualify for a larger loan.
4. Don’t throw a PITI party
What is PITI? It’s the portion of your mortgage that can’t exceed $1,000. Some may call it the “bottom line,” but ultimately it’s the sum of monthly principal, interest, taxes, and insurance. PITI — get it?
If possible, make it a point to buy a house that doesn’t have mandatory homeowner association fees. Why? Believe it or not, these fees are included in your total mortgage calculation.
For example: If you qualify for a $1,200 monthly mortgage payment, and you want to buy a house that has a $200 monthly HOA fee, then the principal, interest, taxes, and insurance (PITI) portion of your mortgage can’t exceed $1,000.
If, by contrast, you want to buy a home that doesn’t have an HOA, the PITI portion of your mortgage can account for the entire $1,200 per month.
Yes, this doesn’t make total sense. After all, a portion of the HOA fee is used to cover exterior maintenance, such as replacing the gutters, roof, and siding. If your HOA doesn’t cover it, then you’ll have to come up with the extra money out of pocket.
But that’s just the way the system works. The formula is designed to count HOA fees against you, but not ordinary maintenance costs, which the lender views as “discretionary.”
5. Maintain a good credit score
This point should be obvious, but it’s worth stating: A high credit score will make your mortgage-qualification process easier. You’ll be more likely to qualify for a mortgage and you’ll be more likely to receive a competitive interest rate.
You can view your credit report for free once a year. This won’t reflect your numerical score, but it will show you a copy of your credit history. Review your history and report any erroneous information immediately. It’s worth purchasing reports from each bureau, as not all creditors report the same information to each, so you may find erroneous items on one report but not another.
Keep your credit score high by paying all your bills on time, keeping your credit-to-debt ratio low, and not opening too many new credit accounts, especially in the six to 12 months before you apply for a mortgage.
6. Don’t take too many deductions
One final tip for the self-employed: If you know you’ll be applying for a mortgage in the next two years, reduce the number of tax deductions you claim. If you state that your business grosses $80,000 in revenue, but has expenses of $75,000, you’ll have a rough time qualifying for a mortgage.
It’s totally fine to take tax deductions, such as contributions to a 401(k) or IRA. But be wary of racking up too many flights to London-based conferences. These business expenses will come back to haunt you in the form of a lower taxable income — which results in a harder time qualifying for a loan.