While there are a lot of perks to being self-employed -- you can make your own schedule, wear what you want to work, and generally be your own boss -- not having a traditional job can cause problems when it comes time to get a mortgage.
It is estimated that some 15 million Americans (about 10.1% of the workforce) were self-employed in 2015, according to the U.S. Bureau of Labor Statistics, and lenders often make things very difficult for those folks. It's not that you can't get a mortgage if you don't have a regular job (the kind where you get a W-2 to file your taxes with), but it does make the process harder.
Why it's so difficult to verify income when self-employed
One of the toughest mortgage hurdles for the self-employed is verifying income. Up until 2006, banks let people who work for themselves take out low-documentation or stated-income loans; the borrower literally told the lender how much money he or she made, and nobody checked too hard. Those loans have mostly disappeared -- which is ultimately a good thing for both borrowers and lenders.
However, unlike folks who work for someone else, the self-employed can't simply show a paystub to prove their income, and they don't have human resources departments to verify their numbers. In general, any lender will want to see concrete proof not only of your income, but of its stability. That means in nearly all cases you will have to provide your two most recent tax returns (which the lender will verify with the Internal Revenue Service).
"As long as the lender can verify the income needed to qualify for the loan, the lender will process and underwrite your loan just as though it were any other mortgage," according to Atlanta banking expert Craig Berry.
Why your tax returns could hurt you
Unfortunately for self-employed individuals, taxpayers naturally tend to maximize their deductions, lowering your taxable income. That's great when the time comes to pay Uncle Sam, but every deduction that lowers your income in the eyes of the IRS also lowers your earnings in the eyes of mortgage lenders.
As one small example, let's say you have a personal vehicle that you use for business. You may want to claim a percentage of your fuel and maintenance costs as a business expense, and that's a legitimate deduction that many self-employed people use. The problem is that how much you take in is not what the lender sees as your income, it's the amount you pay taxes on that matters.
This means that in the two years leading up to getting a mortgage, many self-employed people simply have to leave some deductions on the table. It's not fun, and it's not fair, but that sort-of-business-related trip you planned to write off may lower your income to the point that the bank thinks you can't afford the house you hope to buy.
There are some exceptions to this rule if you were self-employed but no longer are. If you have a year of traditional employment, along with the tax forms to back that up, then some lender will focus on your most recent year and be more forgiving of your previous self-employed year. That's especially true if you have filed taxes as an employed person and are well into a second year in the same job.
What else might the bank want to see?
While in most cases the core lending decision will be made based on tax forms that prove your income, there are plenty of other documents most lenders will want. That's true for all mortgages, but for the self-employed it can be even more intense. Documents a bank or lender will want can include:
- Profit and loss statement. Many small businesses won't have one, but if you have partners or investors, you may be asked to provide one.
- Credit card balances. Your lender will see any credit card balances you owe.
- Bank accounts. Be prepared to share at least two months' worth of bank statements. You may also have to provide new bank statements as they become available up until closing. Generally, these are checked to make sure you have the funds needed for a deposit, as well as any closing costs. You also may need to provide documentation for any out-of-the-ordinary deposits or withdrawals.
In general, be prepared to share any document that might help paint your financial picture. If you have a large contract coming due, then communicate that. The same goes with any non-work-related money like gifts, inheritances, or unexpected casino winnings. Be ready with everything and anything, and realize that it's impossible to hide anything from your potential lender.
Some online companies such as Quicken Loans will provide you with a comprehensive list of documents that mortgage lenders may ask you for. This includes every type of tax form that you may file as a self-employed individual.
Preparation is key
The last thing you want to do is to be stuck pulling your hair out as you sort through old documents in your efforts to prove your income to mortgage lenders. It's always best to be prepared and have all of your documents organized. That way, when a mortgage lender asks you for them, you can provide them immediately. It will save you plenty of time and frustration.
Remember: You aren't alone in the process. Three in 10 U.S. jobs are held by the self-employed and the workers they hire, according to a Pew Research Center report. So when you walk in to apply for a mortgage as a self-employed individual, slap those documents on the table and dare the lenders to give you a hassle.