Being self employed has its benefits and drawbacks. One of the drawbacks being that obtaining a mortgage can be a little more difficult than your typical wage earner. Before the mortgage crisis, borrowers who had a good credit score could literally qualify for a mortgage by just "stating their income and assets". This was called a SISA loan. Understandably, those days are long gone.
Getting a mortgage as a W-2 employee is pretty straight forward. A loan officer will look at your past two years of tax returns, two months of paycheck stubs, and two months of bank statements. It's a simple plug and play formula that calculates your debt to income ratio pretty easily. However, a self-employed borrower will have to go through a little more scrutiny.
What the Process Looks Like
The process of obtaining a mortgage for a self employed borrower is exactly the same as a W-2 employee. After you find the perfect home through a realtor, you'll need to get pre-qualified for a mortgage, get a rate quote, fill out an application, provide documentation, and sign paperwork. A realtor or a loan officer can help guide you with all the factors that go into your pre-qualification. The bank's qualification is identical in terms of down payment, credit score requirements, and debt to income ratio for W-2 & self employed borrowers, so why is it more difficult?
The answer lies in your proof of income. Wage earnings can simply provide paycheck stubs but self employed borrowers will need to show their entire 1040 tax returns including all schedules. If you're a business owner, you probably already know one of the benefits of being self employed is the ability to write off a lot of expenses. This means that your final net income after you write off your expenses is a lot lower. This in itself makes it harder to qualify for a mortgage unless you decrease the loan amount or increase the down payment size. Most lenders prefer your debt to income ratio to be between 31-43%. The exact number will depend on various factors such as your credit score and LTV (loan to value).
From an underwriter's perspective, one of the main things they need to know is whether your business is thriving or steadily declining. In order to gauge this, they'll use Form 1088 to compare your business year over year.
Next, they'll look at K-1 income to qualify borrowers using only cash distributions for the past two years. If the income is consistent and doesn't fluctuate too much, then no further analysis is required.
But There's Good News...
Fannie Mae issued new loan guidelines to the 14 million self-employed borrowers nationwide. One of the main highlights include documentation reduction from two years of federal income tax returns to only one (in certain cases) and new income calculation for borrowers without much income history. The biggest change lies in how Fannie Mae calculates your cash flow. When banks are looking at your documents, they will look at how much money is going in and going out to see if the business owner can afford the mortgage payments. In essence, they're looking for cash distribution to the business owner or the potential cash distribution an owner can make to themselves.
In the past, qualifying for a mortgage as a self-employed borrower meant that borrowers were only allowed to use the amount of money equal to the distributions they received from the company. This was a big issue because if a business owner didn't take cash distributions, lenders might perceive this as a red flag to think the business didn't make enough money to pay its owners. Alternatively, the borrower would've had to provide enough documentation to prove they had immediate and sustainable cash flow they could tap into very quickly.
Now, lenders actually require less paperwork from borrowers. The lenders doesn't require borrowers to confirm that they can document quick access to income. So if you were in a situation where you had multiple business partners, the lenders would have required you to send in partnership agreements. This certainly isn't the case anymore.
Other Tips On Getting a Mortgage
Buying a home is a decision that should be well thought out. It's one of the biggest investments you'll ever make. This is why you should take all the precautionary steps to ensure a smooth process. As a business owner, you should be cognizant about how lenders will look at your income. This means eliminating some deductions that you might normally write off. It may not seem like the best idea at the time, but you'll be thankful you did once you submit all your documents to your lenders.
Next, take a close hard look at your credit score. Zillow reports that self employed borrowers typically have lower credit scores than wage earners. Make sure you're not part of this statistic. Your credit score is heavily weighed on your payment history and overall credit utilization. So if your score isn't in top notch shape, now's the time to work on improving your score. The difference in a few points in your credit score can determine your interest rate and potentially cost you thousands of dollars in interest.