The days of the stated income loan are gone. Even borrowers with substantial assets, steady paycheck, and great credit are being closely scrutinized when applying for home loans in this post financial crisis era. That leaves many self-employed workers wondering if it is even possible to qualify for a home loan. The answer is yes, but…
Many lenders consider self-employment income riskier than a steady paycheck. Preparing yourself to look like a good risk will take a little planning. Follow these 5 steps to put your best financial face forward.
1. Wait Until You Have 2 Years Of Solid Self-Employment Earnings
If you are a newly self-employed entrepreneur, congratulations! You are probably on the road to a fulfilling and financially rewarding career. Unfortunately, in the eyes of a mortgage lender, you are considered more unemployed than self-employed, and that is not going to help you get a mortgage.
Lenders will require 2 years of documented income to approve you for a mortgage, and you want that 2 year history to look really good. It may look great to you to start with almost nothing and see your income steadily doubling ever six months, but it does not look good to a mortgage lender. You see the coming year as bursting with opportunity while the bank sees those first six months of struggle. If the first months or year of your self-employment were spent building your business without much to show for it, you may want to wait until the lean times fall out of the 2-year window.
Some lenders will consider 1-year of self-employment earnings, but be prepared to put more money down and/or pay a higher interest rate.
2. Have Your Self-Employment Tax Returns Prepared By a CPA
The more professional your business looks in the eyes of a potential lender, the better your chances of getting a mortgage. You may have the skills to easily prepare your own taxes, but using a well-respected professional to prepare your taxes will help rub off a little legitimacy on your business. It’s a sign that this is a serious enterprise.
Your CPA will also make sure your income is properly documented. Let them know you hope to buy a home in a couple of years and they will advise you of the type of income documentation that is best for your situation or type of business. They might have some advice on how to structure your business as well. A good CPA is a great person to have on your team.
3. Establish a Stellar Credit Rating
Since you will already be under scrutiny for having what many lenders consider a less dependable source of income, it won’t help to give them another reason to turn down your loan application. FHA loans will require a minimum FICO score of 620 and many conventional loans require 740. If your credit score falls below these levels then you have some work to do.
Check your credit report carefully for any errors that may be dragging your score down. Divorce, moving, finishing school, and other changes can leave marks on your credit that don’t belong there. You will need to contact the credit reporting agency to have these removed.
To improve your credit score, secure and use credit wisely. Charge as much as you can on your credit card and then pay it off religiously every month. Pay your utility bills early to avoid any delays or better yet, set up automatic payment plans for all your bills.
4. Pay Your Taxes
One of the many benefits of being self-employed and running your own business is that you can offset your gross income with reasonable business expenses. Everything from transportation expenses, home office expenses, and even some entertainment expenses are legitimate deductions for self-employed people. While reducing your taxable income is a good thing from a cash flow point of view, it can backfire when it comes time to apply for a mortgage. That’s because a mortgage lender uses the net income, after expenses to qualify you.
If you plan on buying a home, you may want to concentrate major business expenses in one year and then establish a 2 year history of higher net income. This will mean paying more taxes than you might if you deducted all of your eligible expenses, but it will help you qualify for a larger mortgage.
5. Save Some Money
The larger your down payment, the more security you are giving the lender. If you ultimately default on the loan, the lender will have a much better chance of recouping their money from the sale of the property if you put down 20% or even 10%. If there has been a small housing market correction, then the remaining equity is still enough to cover the loan amount.
In addition to a down payment, lenders like to see reserves to cover a minimum 2 months of mortgage payments, property taxes, and insurance. More is definitely better when it comes to cash on hand.
As the housing market recovers and the banking world adjusts to the new reality, it is likely that more mortgage loan products will become available for the self-employed. If you start putting your financial house in order by keeping accurate records, establishing excellent credit, and building cash reserves, you will be ready to take advantage of any opportunity.