Running a small business and obtaining a real estate mortgage are two areas that, when blended, create their own unique challenges. As a national mortgage professional with nearly 30 years in the industry, I’ve helped many borrowers navigate these challenges and offer this advice to help you do the same.
It may seem daunting when you hear “horror stories” of self-employed people who have gone through the mortgage process. I cannot ‘sugar coat’ this, it IS challenging and detailed. But hey, if you are successfully “self-employed” you can handle it.
The “short version” advice
Read the rest of this article to educate yourself. However, in the end if you want to be strategic, prepared and lessen the stress, speak with an experienced, ethical mortgage professional about your goals and current situation. Look for a professional who is not trying to “sell you” a mortgage but will build a relationship with you to help you reach your mortgage goals whether you qualify now, or will need time to get there.
The current mortgage environment for the self-employed
There are certainly many benefits to being self-employed. The potential of freedom, increased income, the satisfaction from building a business, tax benefits, etc. If we were still operating in the financial environment that existed not that long ago, the process of leveraging those benefits into obtaining mortgage financing was as simple as having a decent credit score and “stating your income” on a mortgage application. If the application showed sufficient income and business history to make the qualifying income and debt ratios work the loan was approved! One could even accomplish that with almost no documentation. I know it seems crazy that mortgage lenders were willing to make loans on those terms, and it was. In today’s environment, business owners are forced to jump over hurdles that may seem unfair, and do not make sense when obtaining a mortgage. However, it is part of the consequences from a decade ago.
Think of that past environment as one with a pendulum swung far to one side. Well, we now live in a lending environment where that pendulum has swung far to the other side. The consequences of the mortgage industry collapse from 2007-2010 and the recovering economy over the last five years has placed those individuals who choose to be “self-employed” in an arena that includes many challenges to obtaining a mortgage that salaried employees do not have to face.
“Self-employed” — What Does That Mean?
Let’s start with a basic definition of someone that is considered “self-employed.” Keep in mind that this article deals from the perspective of a mortgage lender. It may not be considered fair and sometimes it does not make sense. But if you are seeking a mortgage, “it is what it is” and
it is better to understand and strategically prepare in order to successfully obtain financing with the least amount of stress possible.
(Important note – guidelines change over time and there are smaller, niche lenders who may have more flexible guidelines for your situation. But there are trade-offs that may be contrary to what you looking for.)
You have no doubt heard of Fannie Mae (FNMA). FNMA exists, according to their website, “to provide reliable, large-scale access to affordable mortgage credit across the country at all times so people can buy, refinance, or rent homes.” They are the largest entity in the country for this purpose and nearly all mortgage lenders in the country follow their underwriting guidelines to some extent.
FNMA states that “Any individual who has a 25% or greater ownership interest in a business is considered to be self-employed.” It is a simple definition. And if you are considered self-employed your mortgage application will be underwritten under those guidelines.
This Part is Just Not Fair
Someone who receives a W2 (and owns less than 25% of their business) may earn income from a salary and that salary can be used to qualify for a mortgage even if they just started their job. Once they have verifiable employment and 30 days history of paystubs that income is considered stable enough to be used to qualify for a mortgage. Even though that person could lose their job at any time, from a mortgage underwriting standpoint they are considered “stable.”
I tell you this because it is an important perspective if you are trying to get mortgage financing. If you are at the stage where you are preparing to start a business and are not yet considered self-employed, you should consider seeking mortgage financing while you are still have W2 income. Even if you have started your business and still have W2 income (from another business which you do not own more than 25%) that W2 income can be used to qualify.
Once you are considered self-employed, the following factors will be analyzed (i.e. verified and underwritten) before receiving an approval for a mortgage:
- Stability of your income
- Location and nature of your business
- Demand for the product or service offered by your business
- Financial strength of your business
- Ability of your business to continue generating and distributing sufficient income to enable you to make the payments on the requested mortgage
So now what?
Every mortgage requires documentation of three areas: income, assets, and credit. When you are self-employed, the documentation required includes those areas for both your personal and business arenas.
The following list should not be considered “black and white” or all inclusive. Different lenders and underwriters will have some variations. Think of this list kind of like the Pirates Laws from Pirates of the Caribbean; in other words, “more of a guideline.”
To document self-employed income you will need to provide:
- 2 years personal tax returns (including ALL schedules)
- 2 years business tax returns (if applicable)
- 2 months bank statements (minimum)
- Depending on the time of year of your application you may need to provide an “un-audited YTD P&L” documenting how your business income is for the time period since your last returns.
- Possible additional documentation may include K1’s if you receive them showing percentage of ownership, copies of business licenses, copies of long term contracts if they demonstrate “guaranteed income,” and a variety of other requests depending on your business.
“Stability, cash-flow, and future potential”
Once a lender has the documentation they will review and analyze it. Lenders are required to create a “cash flow analysis” with your documentation.
Nearly all lenders will require at least two years history of self-employment. While it is true that it is possible to obtain a mortgage with less history, this article will not address those since it would only apply to a very very small percentage of loans.
Your two year history (that means 2 full years of tax returns) will need to show INCREASING INCOME. If your income is declining in the most recent full year, you will have significant challenges to face. The application may still be approved if there is a good reason AND if you qualify using just the income from the most recent year. Lenders tend to assume the worst when it comes to underwriting and if they see a decline in income they assume it will continue. However if your income was impacted by major expenses that can be considered as “one time” expenses the lender may be able to take those losses out of the analysis. That will be part of the cash-flow analysis the lender will do and will include a number of other factors such as depreciation, deductions, etc..
Keep in mind that while you may legally be able to claim a wide variety of write offs and deductions on your taxes your amount of income used for a mortgage qualification WILL BE AFFECTED by those write offs. One of the challenges is that if you anticipate needing mortgage financing you may be forced to limit certain deductions for a period of time in order to increase the bottom line for your qualifiable income.
Lenders will AVERAGE your income
Let’s say you earned $50,000 from your business two years ago and $100,000 last year. Your business is enjoying significant growth and even your YTD (year to date) income is showing even higher income for the current year. In most cases the lender will AVERAGE the LAST
TWO YEARS income for the purpose of qualifying. That means for this example that you would have $75,000/year income used for qualifying for a mortgage. This will be true even if, for example, you had $100,000 income three years ago! The basic guideline will be that they will look for income that is not significantly declining AND will average the past two years. Your YTD income will also need to show that it is on track to be at least last years income.
The bottom line
Whether you are on the way to being self-employed or have been self-employed for years, if you are looking to qualify for a mortgage it pays to educate yourself, be prepared and be strategic. There are countless scenarios for self-employed borrowers. Each case is different. The “basics” explained in this article should serve as a guideline to help prepare you, though it is very important to know that there are many different mortgage options from different types of lenders. Some are more flexible and lenient than others, though that may mean that the terms may not be as good.
From a lender’s perspective, working with self-employed borrowers is time consuming and complicated because of the variety of each borrower and the amount of documentation which must be gathered and reviewed. Seek out qualified mortgage professionals who are willing to take the time to work with you and help you. Be wary of any lender who tries to charge you anything for an application or approval! (You will have to pay for an appraisal but that should only be done after you have confidence that you will be qualified with that lender.)
Joseph Kelly is the creator of the ArcLoan Mortgage Management Program. Mr. Kelly has a unique blend of technical, marketing, sales and leadership experience. As a graduate of the University of Virginia with a degree in Aerospace Engineering (yes….a rocket scientist), he realized that the mortgage industry was lacking a critical component – consumer education. From 1991 to 1996, he was ranked among the top 1% of loan officers in the United States. He has also managed a national call center based mortgage business model since 1998. In 2007, Mr. Kelly joined a nationally licensed, ethical, pro-consumer mortgage company. This allows allows ArcLoan to offer its mortgage management programs/products in all 50 states.