When you own a business or work as a contractor, you’re considered “self-employed” to lenders. It’s not necessarily harder for you to qualify for a mortgage, but it may be trickier for the lender to make sense of your income and expenses. If they don’t have a lot of experience working specifically with business owners, they might only qualify you for a smaller amount, or worse, they might not be able to qualify at all.
A mortgage broker or loan officer with years of experience specifically helping self-employed borrowers can make a huge difference in helping you qualify for the mortgage you desire and deserve.
Who Is Considered “Self-Employed”?
We have found there is confusion between the meaning of “self-employed” and being an “independent contractor.” To lenders, there is no difference. An independent contractor provides work or services on a contractual basis, either directly or through a business that the independent contractor owns. Either way, they are not directly employed by the business and are therefore self-employed.
Tip: Anyone who is not a W-2 employee is considered self-employed* for lending purposes.
Loan Qualification Always Starts with the 4 C’s
Lenders are going to start by looking at the same factors for self-employed individuals that they look at for borrowers who are W-2 wage earners–the 4 C’s: credit, cash, collateral and capacity.
Credit. Credit score matters for any borrower. It’s important for a self-employed borrower to keep their credit score as high as possible, just like anyone else. The higher your credit score, the better the loan terms available to you.
A score of 740 or higher is best, but there are loan options for scores starting at 680 for conventional loans and as low as 580 for government-backed loans. (Learn more about loan types here.) If you’re worried about your credit score, don’t let that stop you from trying to buy a home. Reach out to a good mortgage professional to learn about your options.
Cash or capital. Do you have enough cash for a down payment and closing costs (or equity in your home if you’re refinancing)? Lenders will consider how much cash you have readily available. If you don’t have much cash, there are zero-down mortgage programs available. But lenders also want to know if you have any money in savings (and in reserve for your business).
Collateral – Lenders want to check the fair market value for the property you’re buying with an appraisal. The property is used as collateral against the loan, so lenders want to be sure they’re not lending you more money than the property is worth. (Collateral isn’t evaluated until you have a specific property under contract.)
Capacity. Lenders want to see that you can make the monthly payments on the mortgage. They will look at the total picture of your income and minimum monthly debt payments, or your debt-to-income (DTI) ratio. When you’re self-employed, you can have the same DTI ratio that you have when you’re a W2 wage earner. But calculating your DTI gets a little trickier if you’re self-employed. We’ll explain.
If you’re an employee and are salaried or paid hourly, calculating your gross income and DTI ratio is very simple. (“Gross” means before taxes or any other reductions.)
For example, if you receive a salary of $60,000 a year, divide that by 12 months, and you know that you’re earning $5,000 gross a month. Cut that monthly number in half, and that’s how much you can apply towards your new mortgage and all of your minimum debt payments: $2500.
Let’s say you have these monthly minimum debt payments:
$300 for a car loan $350 for credit cards
$200 for a student loan
Total minimum debt payments = $850
From the $2500 allowed for all your minimum debt payments, a lender would subtract $850, which leaves $1650 for your maximum monthly mortgage payment.
Just because a lender will qualify you for a certain monthly mortgage payment doesn’t mean you should spend the full amount. You need to understand all your financial needs and be sure that you’re comfortable spending that amount every single month. (Please don’t forget to reserve some money for savings!)
Tip: Lenders will usually allow no more than 50% of your gross income to count towards ALL debt payments, including your mortgage. A lower DTI is preferable and may make it easier for you to qualify for a mortgage. Variable expenses such as utilities and cell phone, transportation, food and clothing do not count toward your DTI.
As a self-employed individual, it’s not as simple to calculate your DTI. This is where an experienced mortgage broker or loan officer can help you out.
If you do pay yourself hourly, it’s pretty straightforward to determine your annual and monthly income. Take your hourly rate and multiply it by 2000, which is working about 38 hours per week for 50 weeks. (You can also multiply it by 2080. That’s 52 weeks at about 40 hours a week. Using 2000 is a little safer because people inevitably take some time off, for sick time or vacation or otherwise. We recommend multiplying by 2000.)
For example, if you’re paying yourself $20/hour, multiply $20 by 2000. That equals $40,000 per year.
Divide $40,000 by 12, which equals $3,333/month.
Cut $3,333 in half, and that leaves about $1660/month for your mortgage plus your minimum debt payments.
What if Your Income Fluctuates?
Let’s face it, for many self-employed individuals, as well as those who are paid by commission and bonuses, your income is variable. Your income may be seasonal, it may depend on market cycles or it may change based on a number of factors. Your business might do very well in one month and do a little less the next month.
As a result of fluctuation, lenders want to see a 2-year income history based on your tax returns, and they will take an average of those 2 years.
If your business doesn’t have 2 full years of tax returns yet, it could be a challenge. Lenders DO require 2 years of tax returns and there’s no getting around that. If you don’t have 2 full years of business operations reflected on your tax returns, unfortunately you may only qualify for a lesser amount or not qualify yet. For example, if you have one full year’s tax return and only a half year of income on the 2nd return, your income average will be brought down, because the lender requires a 2-year average to calculate the monthly income. You might need to wait to qualify for a larger mortgage.
If you’re new to a sales job and paid a commission on top of your salary, the commission may not be used in qualifying until you have a 2-year history of that commission. If the salary is stable, you can use the salary immediately to qualify. You don’t have to be employed in that job for 2 years; you don’t even have to be in that job for 6 months. Sometimes borrowers can get qualified even before they’ve started a job if they have an offer letter; the loan officer can calculate what their income is going to be and determine the DTI ratio as a result.
Another thing to be aware of is that you might have a great year one year, and then the next year your income drops. If there is a 25% or more drop in income year to year, lenders will do one of two things:
1. They may say you don’t qualify at all.
2. Or, most will say they will only consider the lower year’s income. They’re concerned about a trend of reduced income. They want to know that you can make the mortgage payments. If you’re on a downward trend, they don’t know when the bottom of that trend is, and they want to reduce their risk of you defaulting on the loan. They will use the lower tax return, especially if there’s a good reason for it (such as a pandemic or a big change in the market), as long as you can show you’re trending back up.
Tip: Here’s a cool tip that not every loan officer is aware of. The guidelines state that if you’ve been in business for 5 years or more, you can actually use a 1-year business return. For example, the covid pandemic hit in 2020, and many people’s businesses suffered. But many got back on track in 2021. If you’ve been in business for 5 or more years, lenders don’t have to use a 2020 and 2021 average. Lenders can just look at 2021 taxes and use that higher income to help you qualify for a bigger mortgage.
Calculating Net Income for Business Owners
Another thing for self-employed individuals to take into account is gross income vs. net income. When you’re self-employed, lenders don’t look at gross income to qualify you for a loan. Lenders look at the bottom line, the net number after expenses. And expenses can fluctuate and make your business look less profitable. Sometimes there are one-time expenses, such as a big piece of machinery you had to buy, or maybe you sold a piece of equipment.
As a self-employed business owner, there are some expenses that you might be using your business to pay. For example, say a self-employed individual has a truck that is owned by their business and the business pays for that expense. It’s an expense to the business, so it reduces the bottom-line income for the business.
Taxable Income and Mortgage Qualification
We all want to reduce our tax liability. You can write off a lot of expenses as a business owner. As a result, you report to the IRS a much lower bottom line income, because that determines what you pay taxes on. But you may need to consider that by showing the lowest possible income on your tax return, you may not be able to qualify for the mortgage you want.
Tip: You can consult with a knowledgeable mortgage guide to help you strategize how to balance your taxable income with showing enough income to qualify for a mortgage. A great mortgage guide can advise you and will even be willing to review your tax return before you file it to make sure you’ll qualify for the mortgage amount you want.
Depreciation for Business Owners – It’s Awesome
Also, as a business owner, you can use depreciation to reduce tax liability, and depreciated expenses may not reduce your income to qualify for a loan. For example, if you buy a vehicle or certain equipment for your business, you may be able to depreciate it, and that allows you to reduce your tax liability and cut your taxes, saving you money for your business.
Depreciation is a tax tool. There’s not an actual expense going out of your pocket for that expense, so an informed lender can add that number back to your qualifying income. Depreciation is awesome for business owners! Depreciation can apply to employees too; the self-employed simply have more options for increasing depreciation. (Please talk to an accountant or tax adviser to learn more about depreciation and your personal situation.)
What We Recommend to Self-Employed Individuals
Talk to a few different loan officers or mortgage brokers who have experience helping business owners qualify for a mortgage, find somebody you like and trust (even better if they own their own business too!), and send them your personal and your business tax returns for the past 2 years. Include your K-1s with your business returns. From those tax returns, they should be able to get you qualified within a day or less. It’s a very quick process if they’re good at what they do, even if your tax returns are somewhat complicated.
It’s not much more difficult to qualify for a mortgage if you’re self-employed or have variable income, but it is trickier for the less experienced loan officer who doesn’t look at tax returns every day. Save yourself some worry, and work with an experienced loan profesional. We can help you find a great mortgage guide.
*“Self-employed” by definition means that you own 25% or more of a business. If you own less than 25% of a business, tax returns for that business are not used to qualify. Hopefully you have another source of income, or you can show some income from a K-1. For example, if you’re part of a family trust or you own a small percentage of a business venture you’ve participated in, you would receive a K-1 that you could show for additional income.