In the changing economy, the expectation is that more of us will be self-employed. While that can offer a lot of advantages, it can also make it more difficult to qualify for a mortgage when you want to buy a home.
As your own boss, it's likely that lenders will view you as a bigger credit risk than someone who receives a regular paycheck. This is particularly true if you've only been in business for a few years and haven't yet established a firm track record of success.
In addition, being self-employed can present some unique challenges in terms of documenting your income to a lender, in part because your earnings can fluctuate from year-to-year but also because of the way you report them for tax purposes.
You may also find that banks will charge you a somewhat higher interest rate than they would for "preferred" borrowers with similar credit scores to yours but more predictable incomes.
Documenting your earnings
As a self-employed person, the most common way to document your income is through your tax returns. The lender will likely want to see two years of tax returns and will want to obtain the information directly from the IRS -- you can't simply give them copies of your own.
The way you do this is by submitting an IRS Form 4506, which allows the lender to receive or inspect copies of your tax return. Another possibility is Form 8821, which authorizes the IRS to discuss your return with a third party (i.e., the lender). Either way, it enables the lender to verify your earnings over the past two years.
In some cases, the lender may not require that you provide access to your tax returns but instead may allow you to submit earnings reports from your business and a list of clients, as well as documenting any other income-producing investments you may have.
Tax deductions can reduce your income
Tax deductions can sometime be a problem for self-employed persons who are seeking a mortgage, because they effectively reduce your reported income. Maximizing your allowable deductions means minimizing the income you report to the IRS, so it looks to the lender like you didn't make as much as you feel you did.
The lender won't look at your deductions and assume that your "real" earnings are higher than stated and so you can take on more debt -- they're going to assume your adjusted gross income is what you have available to pay your debts with.
If you need more income, it's possible to cut back on deductions for a couple years so you can report more earnings, but that doesn't work very well in practice -- for one thing, it means paying more taxes in those years. You're better off getting your other debts paid down so your debt-to-income ratio will be acceptable with the adjusted gross income you've reported.
Most lenders will require that your total debt-to-income ratio -- that is, how much of your monthly income goes to debt payments -- not exceed 36 percent of your pretax earnings. They also like to see no more than 28 percent of your income going toward housing debt, including your mortgage, insurance and real estate taxes.
Usually, lenders will take the average earnings from your two years of tax returns to figure what your allowable debt-to-income ratio would be. If your earnings fluctuate, they'll also likely to limit your debt-to-income ratio to no more than 50 percent of your pretax income in your lowest earning year.
If you're self-employed, your lender may also want to see evidence that you have cash reserves to tide you over a slow period -- at least enough to cover two months of mortgage payments. They may also require a larger down payment than they would from borrowers who receive a regular paycheck.
Like any mortgage borrower, you'll want to have a good credit score in order to get the best rates. These days, that typically means a FICO score of 740 or better. You can still qualify for an FHA mortgage with a score as low as 620-640, although you'll pay a significantly higher interest rate than borrowers with excellent credit.
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