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Navigating Self-Employment and Mortgages: A Guide to Building a Strong Mortgage Profile
Introduction
As self-employment becomes an increasingly popular career path in the United States, many people are finding themselves needing to navigate the often-complicated world of mortgages as an independent contractor. While being self-employed comes with a host of benefits and freedoms, it can also present unique challenges when trying to secure a mortgage.
Defining red flags for self-employed borrowers
When evaluating a self-employed borrower, lenders typically look for a few key red flags. One of the biggest is an inconsistent or uneven income stream. Unlike a salaried employee who typically has a steady paycheck, freelancers and independent contractors may have unpredictable income from month to month. This can be a major concern for lenders, who are looking for borrowers who can reliably meet their mortgage commitments. A second red flag is high levels of debt and expenses. Self-employment can come with additional expenses, such as insurance premiums or equipment costs, which can eat into a borrower's income. This can make it more difficult to meet the debt-to-income (DTI) ratio requirements that lenders impose when evaluating mortgage applications.
Building a sufficient mortgage profile as a self-employed individual
Differentiating between legal statuses
Before we dive into what documents and other factors can help build a strong mortgage profile, it's worth noting that not all self-employment looks the same in the eyes of the law. From a legal standpoint, there are several different ways to be self-employed, including sole proprietorship, partnership, and LLC. The legal structure of your business can impact things like liability and tax obligations, but it can also affect how lenders evaluate your application.
Key documents
Regardless of your legal status, there are certain key documents you'll need to provide when applying for a mortgage. These might include tax returns (both personal and business), bank statements, profit and loss statements, and a list of clients or customers. In particular, lenders will scrutinize your tax returns for the past two years to get a sense of your average income. It's important to keep good records of your business finances, as this can help demonstrate a stable and consistent income stream.
1099s vs. W2s
Another factor that can impact your mortgage application is whether you give 1099s or W2s to your employees or contractors. If you are a sole proprietor or LLC and use contractors, you likely give them 1099s to report their income to the IRS. However, if you have employees, you will need to give them W2s instead. This can be an important distinction for lenders, who may view employees as a more stable and reliable part of your business than contractors.
Necessary adjustments to income streams
It's worth noting that when lenders evaluate your income, they may make certain adjustments to account for business expenses or other deductions. This can result in a lower income figure than you might expect. For example, if you make $100,000 in revenue but have $50,000 in deductible expenses, a lender may only count your income as $50,000. It's important to understand how lenders calculate income and to be prepared to provide additional documentation or explanation if needed.
Alternative forms of proof of income
If you're having difficulty meeting the typical income requirements for a mortgage, there may be alternative forms of proof of income that you can use. For example, some lenders may consider bank statements or other financial assets as evidence of your ability to make mortgage payments. Additionally, certain lenders may offer "bank statement loans" that evaluate income based on deposits to your bank account over the past several months rather than tax returns.
Leveraging strength in other areas
Debt-to-income (DTI) ratio
If you're having trouble meeting typical DTI requirements, there may be ways to strengthen your application in other areas. For example, you may be able to pay down existing debt to improve your DTI ratio, or you might be able to space out large purchases to avoid adding to your debt load.
Liquid assets
If you have a substantial amount of liquid assets, such as stocks or mutual funds, this can also help strengthen your mortgage application. Lenders view these assets as a sign of financial stability and may be more willing to overlook other red flags in your application if you have a significant level of assets on hand.
Compensating factors
Finally, there may be other factors you can use to "compensate" for weaknesses in your application. For example, if you have a solid credit score or a long history of stable income (even if it's freelance income), this can help make up for other red flags. You may also be able to secure a co-signer or use a down payment to offset other concerns.
Conclusion
As a self-employed individual, the mortgage application process can be complex and daunting. However, by understanding the red flags that lenders look for, providing strong documentation to demonstrate your income, and leveraging other strengths in your application, you can increase your chances of securing the mortgage you need to purchase your dream home. It's important to consult with a trusted financial advisor or mortgage professional for guidance and support throughout the process.