If you’ve built a successful business or freelance practice, you may be feeling financially ready to buy a home. Unfortunately, getting a mortgage when you’re self-employed can be a longer and more complicated process than you may have expected. Even if you know you can afford the monthly payments, getting a lender to understand that is another story.
Fortunately, getting approved for a self-employed mortgage is possible, but you need to understand that the process works very differently compared to borrowers who receive W-2 income. Understanding what lenders actually look for will give you a big advantage when you’re applying.
Below we’ll look at how lenders evaluate self-employed income, what your loan options are, and how to set yourself up to maximize your chances of approval.
Are you considered self-employed for mortgage purposes?
Self-employment for mortgage purposes is defined slightly differently from how you might think about it. Generally, a lender will consider you to be self-employed if you own 25% or more of a business, receive 1099 income, or file a Schedule C on your personal tax return. These guidelines apply not just for sole proprietors, but also LLC owners, partners in a partnership, and shareholders in an S-corp.
However, an important exception concerns mixed income. If you have W-2 income, such as from a part-time job, and that income is enough to qualify for the mortgage you want, then your lender may not need any self-employment documentation at all. But if you also need your self-employment income to qualify, you’ll be considered self-employed.
Why getting a mortgage is more complicated when you're self-employed
Self-employed borrowers trying to buy a house face significant barriers when getting a mortgage. That’s because lenders automatically treat anyone who doesn’t have W-2 income differently. Because you won’t have a pay stub that clearly summarizes your earnings, lenders have to rely on different documents to get a complete picture of your financial situation.
Your qualifying income is probably lower than what you actually earn
Lenders don’t qualify you based on your gross revenue. Instead, they look at your net income as reported on your tax return. Ironically, if you’ve been diligent about deducting business expenses, you could end up hurting your chances of getting a mortgage since your qualifying income will appear lower than what you actually take home.
As Andrew Gosselin, CPA and Senior Contributor at Save My Cent, says, “Many self-employed people do their tax job well, lowering taxable income with write-offs; however, this can play against them later, because what helps you pay less taxes is what the bank looks at when calculating how much to lend.”
This situation means that although you may personally know you’re capable of covering the mortgage, the lender may only take into account your taxable income. "If your business has $150,000 in gross revenue but only has $50,000 in business income after the deduction (due to aggressive write-offs and expenses), it is the $50,000 that will be utilized by the lender when underwriting the mortgage,” says Matt Bigach, Co-Founder of Nexus Homebuyers.
It’s important to point out that depreciation deductions get added back because they represent a paper loss instead of cash out of pocket. These deductions can help increase your qualifying income somewhat. But not all deductions can be added back, so this aspect will provide only limited help.
Lenders average your income over two years — and use the lower number if it drops
Most lenders will average your income over the last two tax years to determine your qualifying income. However, there’s a big caveat if your income is declining. “If a borrower's income is rising, that can help. If it’s declining, lenders may use the lower, more recent number,” says Jake Vehige, President of Mortgage Lending at Neighbors Bank.
So, if you net $90,000 in year one and $70,000 in year two, your lender may qualify you as having an income of $70,000 rather than $80,000 (which would otherwise be the average across the two years).
Frustratingly, if your income rises from one year to the next, that won’t necessarily help you either. “Stability is the single most important factor for lenders," Martin Orefice, CEO of Rent to Own Labs, points out. "They don't care if you brought down six figures last year if you brought down 10K the year before that.”
If your income across the last two years is very unstable (even if it’s increasing), lenders will be more nervous to lend to you. Lenders want to see that your income is stable and that your ability to cover mortgage payments won’t depend on one good or bad year.
You'll need to document more than just your income
Self-employed borrowers have to submit far more paperwork than employed borrowers do. You need to prove that your business exists and is operating and that your income is stable. That means providing copies of business licenses, profit and loss statements, multiple years of tax returns, 1099s, K-1s, and more.
Plus, your specific document requirements will depend on your business structure and the type of loan you’re applying for. These shifting requirements can be a point of frustration and can add to the amount of time it takes to apply for a mortgage.
Even if all of your documents are in order, there’s no guarantee you’ll get approved. Matthew Thompson, a real estate broker himself and Founder of OwnerWebs.com, applied for a mortgage as a self-employed person, and recounts that, “the lender required everything one can think of. Bank accounts, credit, tax returns, houses, cars, insurance, taxes, etc. Even after all that, still no approval.”
Not all lenders know how to handle self-employed income
Unfortunately, even people who are perfectly capable of paying their mortgage can get denied if they’re self-employed simply because many lenders aren’t equipped for the process. Thompson continues: “I know how much money I have coming in and whether I can afford it. If I'm averaging $100,000 in monthly income I can easily be confident that I can afford a $5000 mortgage. Try telling that to a bank or mortgage lender though.”
Many lenders simply aren’t equipped to handle borrower applications that don’t include W-2 income. That’s because self-employed underwriting involves a lot more discretion, analysis, and specialized knowledge. Especially at big banks, loan officers may struggle with the nuances of business income.
Loan options for self-employed borrowers
Self-employed borrowers have access to the same types of loans as everyone else. But there are important nuances to be aware of. Here are the four main loan options for the self-employed.
Conventional loans
Conventional loans are the most common mortgage type for both employed and self-employed buyers. They come with competitive interest rates, as low as 3% downpayment requirements, and they’re widely available. You’ll generally need a credit score of at least 620 and your debt-to-income (DTI) ratio will be key.
If you’re self-employed, conventional mortgage requirements are typically at least two years of personal and business tax returns. However, if you have sufficient W-2 income, you may not actually need to document any self-employment income at all.
So long as your income is stable and you don’t have any obvious risk factors on your credit report (such as a recent bankruptcy), then a conventional loan is a good option.
FHA loans
FHA loans are federally-backed mortgage options designed to make home loans attainable to borrowers who may otherwise not qualify for a conventional loan. They offer a lower credit threshold of 580, downpayment requirements of just 3.5%, and more flexible DTI limits of up to 50%.
That flexible DTI ratio can be especially appealing to self-employed borrowers who may have an artificially low income due to tax deductions. Plus, if your personal tax returns show increasing income over the past two years and your closing funds aren’t coming from a business account, you may not even need to show business tax returns.
However, if your credit score is high, you’ll still likely get a better rate and terms with a conventional mortgage. FHA loans tend to be a better fit for first-time buyers or those with credit challenges. You’ll also need to apply through an FHA-approved lender.
VA loans
VA loans come with some of the best terms of any mortgage type. There’s no minimum down payment, no private mortgage insurance (PMI) requirement, and interest rates are generally competitive, depending on your credit profile. These factors can make a mortgage much more attainable for self-employed buyers, especially if their qualifying income is low.
However, the same two-year documentation requirements apply to VA borrowers as they do to conventional loans. Plus, only veterans, active-duty service members, and some of their family members are eligible for VA loans.
Bank statement loans
Bank statement loans are specifically designed for people with strong cash flow but low taxable income, which is exactly the type of situation many self-employed borrowers find themselves in. Instead of relying on tax returns, bank statement loans are based on the last 12 to 24 months of bank deposits. As a result, lenders look past your write-offs and instead at the cash that’s in your accounts.
"Bank statement loans are very common for strong business owners," says Cody Schruiteboer, Founder and President of Best Interest Financial. However, these are considered non-QM (non-qualified mortgage) products, meaning they’re less standardized and riskier for lenders. As a result, they tend to come with tradeoffs.
"Rates are usually a bit higher (often 0.5–1.5% more than conventional), and down payments are typically 10–20%, but they solve the 'tax return problem' cleanly," says Schruiteboer.
Documents needed to apply for a mortgage when self-employed
Document requirements vary depending whether you’re applying for a traditional loan or a non-QM bank statement loan. Here’s the breakdown of the documents required for each.
Traditional (tax return-based) loans:
- Two years of personal tax returns with all schedules
- Two years of business tax returns, including:
- Schedule C for sole proprietors
- Form 1065 for partnerships
- Form 1120S for S-corps
- Profit and loss statement
- Confirmation of self-employment status, such as a business license
- 1099s and K-1s as applicable
Bank statement loans:
- 12 to 24 months of business bank statements
- Confirmation of self-employment status, such as:
- Business license
- Website
- Professional listings
- Association memberships
- Profit and loss statement
- Freelancers/contractors may be asked to provide client contracts or invoices
While bank statement loans have fewer requirements on the surface, borrowers applying for this loan type often get tripped up by commingled personal and business accounts. When business and personal expenses aren’t separate, the lender has to manually itemize transactions, which leads to delays. Keep your business and personal accounts separate from day one to increase your odds of approval.
What if you've been self-employed for less than two years?
Most lenders require two years of self-employment history in order to qualify you for a loan. This two-year period gives lenders enough time to judge how stable your income is and what level of risk you present as a borrower.
However, there are still paths to getting a mortgage depending on where you are in the timeline:
- If you have at least one year of self-employment history, some lenders will show flexibility and qualify you. However, you’ll need to show that you have a strong history before that in the same or a closely related field, such as by providing W-2 statements from a previous employer. Relevant education or professional training may also count.
- If you have at least 12 months of self-employment income, some non-QM lenders may qualify you for a bank statement loan. However, the interest rate may be higher, and you'll probably need to have at least 10–20% to put down.
- If you have fewer than 12 months of self-employment income, qualifying will be extremely difficult. But you could potentially apply with a W-2 co-borrower (if one is available) or simply wait until you cross the 12-month mark and use that time to build your cash reserves and credit.
If you’re not yet at the point where you can get a mortgage (or, at least, a mortgage with acceptable terms), most good lenders will work with you on developing a plan. They can assist you by identifying exactly what you need to qualify, how to organize your records, and how to improve your credit.
“We’ve helped many business owners qualify successfully — often after being told 'no elsewhere — simply by structuring the file correctly from the beginning," says Schruiteboer. "Secondly, we don't ever land on a firm no, it’s just not right now and creating a plan on what needs to happen so xyz can be accomplished.”
How to find the right lender for a self-employed mortgage
Not all lenders are qualified to handle self-employed borrowers. Some don’t have the underwriting experience or even offer the type of loan products that self-employed borrowers need.
When evaluating potential lenders, focus on those who regularly work with self-employed borrowers. Ask lenders upfront exactly how they calculate qualifying income. Since self-employed income can be dramatically affected by deductions, this point will make a meaningful difference in how much of a mortgage you’re able to get.
Mortgage brokers can be a good option here as they can match your financial profile with a suitable lender.
"Many big banks don’t offer flexible programs and will simply decline the file," says Schruiteboer. "Self-employed borrowers should start with a broker who reviews tax returns up front, runs multiple qualification scenarios, and has access to both conventional and non-QM options."
How to prepare for a stronger mortgage application when self-employed
Beyond doing what you should do to apply for any mortgage, there are other steps that apply specifically to self-employed borrowers. Here’s what to do to improve your chances of getting approved for a mortgage if you’re self-employed:
- Keep business and personal finances in separate accounts. “ALWAYS maintain separate business bank accounts and do not commingle funds," says Alex Olivera, Owner and Broker at Patriot Mortgage Group. Not only is this wise from a tax perspective if you’re ever audited but it makes it 10x harder if you have to go through a bank statement loan and we have to have you itemize 2 years’ worth of transactions to figure out what was a business expense vs. personal.”
- Run all business income through one primary account. This will make it easier for lenders to assess your income. Olivera notes, “If you are a contractor and take on 3 jobs, giving you 3 separate 1099s, be sure to file them all as the same business so it doesn’t appear to be 3 different businesses when it is really the same ‘job.’” However, before restructuring your accounts, talk to a CPA.
- Build cash reserves. “Build a year’s worth of cash reserves,” advises Mark Cohen, CEO and Founder of Cohen Financial Group. Doing so not only makes your application stronger, it also protects you in case of fluctuations in your income.
- Consider modifying your tax strategy a year or two before applying. Talk to your accountant and loan officer well in advance of when you plan to buy your house so you can strategize, such as by toning down your write-offs in order to increase your qualifying income. “A small strategy shift can make a big difference in your file,” says Vehige.
- Keep track of your credit score. While your credit score isn’t as important as your income and cash reserves when applying for a mortgage, it has a significant impact on interest rates. Cohen recommends maintaining a credit score of 680 or higher. "Interest rate pricing is a grid," he says. "The higher the score, the better the pricing.”
Connect with a loan officer to make a plan
Whether you’re thinking of applying for a mortgage today or in a few months, talking to a loan officer now can help. An experienced loan officer can look at your current financial profile and advise you on your mortgage options.
At Best Interest Financial, we provide personalized, white-glove service that big-box and automated lenders can’t. With over 80 years of combined experience and billions in closed loans, our loan officers have the expertise to help identify creative financing possibilities that others miss.
No matter what your timeline is, we can help you develop a strategy to reach your goals and get you on the path to home ownership. Get a free, 60-second quote from Best Interest today to learn more.