Self-employment has many perks. You can often work when and where you want, and you don't have a boss looking over your shoulder. But it also has some drawbacks, especially if you're just starting out. Being self-employed can make it more difficult to get approved for a mortgage, because lenders have a harder time assessing your income.
But that doesn't mean you can't get approved. If you understand how lenders consider mortgage applications and self-employment income, you can take steps to make yourself more appealing. Here are some things you need to know about how to get a mortgage when you're self-employed.
Showing enough income is the biggest challenge
Lenders want to make sure they'll be able to get back the money they lend you, so it's important that you show enough income to cover the mortgage payments easily. This isn't difficult when you have a W-2: A steady paycheck gives lenders confidence that you will continue to have money coming in.
When you're self-employed, however, your income can fluctuate, and there's always the chance that it could sink so low that you cannot afford to pay your bills. That's why mortgage lenders typically require self-employed individuals to show two years' worth of self-employment income to prove that they have a steady revenue stream. You'll have to provide tax returns from the last two years, and you may also have to provide a list of your existing debts and assets. Business owners may have to provide profit and loss statements from the last couple of years.
What makes it all even trickier is that lenders consider your income after deductions. So everything you're writing off for your business -- phone and internet services, office supplies, business trips, etc. -- may help to lower your taxes, but it also lowers your income in the eyes of mortgage lenders. This, in turn, raises your debt-to-income ratio, which is a measure of how much money you have coming in and going out each month. Most mortgage lenders will not give you a loan if that ratio is greater than 43% -- that is, if more than 43% of your income is going toward paying off debt each month.
But if you're earning a steady income from your work and you can prove that it has either stayed the same or gone up over time, you may not have any trouble getting a mortgage. But there are other factors besides income to consider.
Other factors that affect your chances of approval
As I mentioned above, lenders look at your debt-to-income ratio when considering your mortgage application. It doesn't matter if you make $1 million a year if $990,000 of it is going toward paying off debt. So it's important to make sure you keep your debts down to a manageable level. They should never exceed 43% of your income, and it's best if you can keep your obligations under 36%.
Your credit score also matters. This is a measure of how responsible you've been with borrowed money in the past. Lenders use it to assess the risk in lending to you. They may be hesitant to do so if you have a number of late payments and repossessions on your credit score, or if you have a high credit utilization ratio (the amount of credit being used divided by the amount of credit available). It's important to keep your credit score as high as possible if you want to give yourself the best chance of getting approved.
What to do if your application is denied
If your mortgage application is denied, the first step is to figure out why so you can take steps to correct it. The lender should give you some indication as to why it denied your application, so this can give you a good starting point.
If it was because you couldn't show enough income, you have a few options. You can try making a larger down payment, if you can afford to do so, to lower the amount of the loan. Or you can see if someone you know would be willing to cosign on the loan for you -- though you should keep in mind that this carries lots of risk and no reward for the cosigner, so it's not a favor you should ask lightly.
If the problem is that you have too much debt, you should focus on paying this off before you reapply for the mortgage. This will help you in two ways. First, it will lower your debt-to-income ratio. Second, it will lower your credit utilization ratio, which will help to boost your credit score.
Ideally, one of these strategies will enable you to get the home you want. But if not, you may just have to wait and try again later. Work on boosting your self-employment income and reapply when you start to earn a little more money. Keep all of your financial documentation in order so that you have it all ready to present to your mortgage lender when you reapply.
Self-employed individuals have a couple of extra hurdles to clear when it comes to applying for a mortgage. But it's still possible to get approved, provided you can show that your business is a steady source of income.