2021 Mortgage Guide for Self-Employed Borrowers Roger Odoardi Table of Contents Introduction Self-Employed Borrowers & COVID-19 The Mortgage Loan Process for Self-Employed Borrowers Tips for Self-Employed Borrowers Introduction It’s no secret that one of the most important factors in getting qualified for a home mortgage loan is income. Lenders, both large and small, justifiably want to know that you have money rolling in on a consistent basis, as this is a good sign that you’re able to repay the money you borrowed. Traditional home buyers are able to prove this by providing a W2 from their employer indicating just how much money they make week-to-week or month-to-month. However, things get a little bit trickier when we start talking about mortgages for self-employed individuals. Here’s why: Showing Your Income is Key to Applying for Mortgages for Self-Employed Home Buyers Unlike a traditional home buyer, self-employed home buyers can’t simply produce a W2 to prove their income. Instead, self-employed applicants are expected to produce evidence of their last two years in tax returns. Coming up with this information, in addition to other supporting documentation, can be onerous, so be prepared to do some work. Regardless of how long it takes to come up with this information, it’s a good idea to have these documents ready to go when applying for a mortgage. The real challenge comes when it’s time to clear up any discrepancies between what a self-employed borrower thinks they make in income, and what their tax returns say. The Most Common Problem in Obtaining a Self-Employed Mortgage Loan The most common problem self-employed individuals encounter when applying for a home mortgage loan is differentiating between how much they claim they make, and the amount the government decides they actually make in net income, according to their tax returns. Despite having plenty of cash flow on hand, not to mention access to credit through their business accounts, self-employed individuals are often shocked when they learn just how much their net income actually is after factoring in tax write-offs and other business expenses. For example: A self-employed electrician may make $200k in gross sales, but if they write off $190k, they’re left with $10k in taxable income. Their gross revenue is much different from their net income. Fannie Mae and Freddie Mac, as well as the FHA, all base their lending decision on net income. But what do loan companies consider self-employment? Fannie Mae and Freddie Mac consider anyone who owns at least 25% of a business as self-employed (even if they are otherwise employed by someone else). Over the last several years, the big loan companies have become more discerning: They’re taking a magnifying glass to tax returns and looking more closely at year-to-date profit and loss statements from borrowers. Self-Employed Borrowers & COVID-19 The COVID-19 pandemic has had devastating effects on the world economy in 2020. In the U.S. alone, we’ve seen record rates of unemployment and unprecedented business revenue losses. As a result, many self-employed prospective home buyers have had to put off their big purchase until their income stabilizes. Lenders have implemented some new guidelines in the age of COVID-19: Profit and loss statements must be audited by a CPA – In 2020, Fannie Mae and Freddie Mac have stipulated that, even if a profit and loss statement is prepared by the borrower, it must be audited by a CPA firm. If unaudited at the time of your loan application, you will need to provide your three most recent business bank statements, to prove that the business is still active and operational, and that its activity is consistent with stated profit and loss. Non-qualified loans are more common – While almost all mortgage loans are conventional in that the borrower meets all the lender’s criteria, 2020 has seen a rise in non-qualified mortgages, or non-QM. Many self-employed borrowers have taken this route, as it does not require that they produce tax returns (only bank statements) and it allows them to extend mortgage payments past the standard 30 years. There are also higher interest rates associated with non-QMs. So now that you know the challenges before you, let’s talk about the best way to approach qualifying for a self-employed mortgage loan. The following step-by-step guide should help: The Mortgage Loan Process for Self-Employed Borrowers Step 1: Gather all documents As mentioned earlier, getting your tax returns in order is of utmost importance. While most government-backed loan programs require at least the last two years’ worth of tax returns, there are in fact some conventional loan programs that only require one year’s worth, which is great for applicants who’ve been self-employed for less than two years. Either way, try to get your last two tax returns if possible. In addition, you’ll want to gather other important tax documents that your lender may require. These include: Tax identification number Schedule C Schedule E Form 1120-S K-1 Profit and Loss Statement The structure of your business will dictate the types of documents you’ll need. For example, if you’re an independent contractor, in addition to the documents above, you’ll also need: Invoices Letter of Verification of Self Employment from a CPA And if you run a larger operation, you’ll need: Business tax returns References Letter of Verification of Self Employment from a CPA Getting ahold of past tax returns and other supporting documents should be simple. Most self-employed individuals can turn to their accountants for this information. In addition to tax forms, you may also need certain documentation that proves your self-employment. These documents could include: Business license – This document is typically issued by the state, city or county, and should include the mortgage applicant as the business owner, along with the name of the business. Letters from clients – You’ll need to provide a minimum of one letter from the customers/clients you service. These customers/clients must be legitimate businesses. Letters should be on letterhead and include contact name, type and date of service. Miscellaneous documentation – Other documents you may need include proof of bond insurance and membership to professional organizations, as well as documents that indicated you’re DBA (Doing Business As). If this seems like a lot of paperwork, don’t feel singled out — all borrowers, regardless of employment type, must provide extensive documentation of income to qualify. Step 2: Meet with your broker/lender Schedule a meeting with your broker/lender and be sure you have all the answers you need to proceed with buying a home. A lot of times, the lender or broker assisting you will be able to take a look at your tax return and tell you immediately what your chances are of getting approved for a self-employed mortgage loan. If you’re concerned you might encounter an issue involving your net income as outlined above, it may be a good idea to bring your accountant with you to the meeting. Download our free eBook to learn the 10 must-ask questions when buying a home. Step 3: Plan, prepare and apply The third and final step is the most crucial of all. If you’re like the countless other self-employed individuals who encounter issues with getting a mortgage due to discrepancies in their net income, it’s a good idea to make the following adjustments when preparing your upcoming tax return. Here are few things you need to do: Don’t write off nearly as much as in years past! Tax write-offs are likely what caused your net income to be so low on past tax returns, so try and avoid writing everything off for your upcoming return if possible. It may sting, but it’s the most effective way to prove to a lender that you are worth more than what your past tax returns indicate. Clean up your finances so that your business doesn’t mix with your personal funds. If you have equipment you use for your business listed on your personal credit report, be sure to try and clear all that up before applying for a mortgage. Tips for Self-Employed Borrowers With some careful planning and meticulous recordkeeping, you should have no problem getting a self-employed mortgage loan — no matter if you’re a cash-strapped freelance writer, a self-employed contractor or a private small business owner. Here are some tips to streamline the self-employed borrower experience: It’s OK to wait – With non-QM loans, it can be tempting to jump at the chance to buy a home before you’re financially stable. Waiting to qualify for a standard mortgage loan is recommended, to save yourself and your loan officer from a potential future hassle. Reduce your personal debt – If you’re holding off on buying a home until you’re approved for a qualified mortgage loan, you can start reducing your personal debt. Refinance existing loans (like car and student) and work on improving your credit score. Don’t worry what the seller will think – Luckily, sellers don’t know or care if buyers are self-employed — and as long as your loan officer can verify that your income is stable, self-employed borrowers are treated like everyone else. Consider whether you really need a co-signer – Self-employed borrowers might feel safer having a loan agreement co-signed. However, this may cause complications; if your prospective co-borrower doesn’t have/need an income, it’s easier to leave them off. Blue Water Mortgage is licensed in New Hampshire, Maine, Massachusetts, Connecticut, Florida, and North Carolina. While it may be true that being a self-employed borrower means more work for you up front, Blue Water Mortgage is fully equipped to help you succeed. We work with self-employed home buyers all the time to help them qualify for a mortgage loan that works. Contact us today to learn more about how we can help you get the mortgage you need to buy the home of your dreams. Roger Odoardi Roger is an owner and licensed Loan Officer at Blue Water Mortgage. He graduated from the University of New Hampshire’s Whittemore School of Business and has been a leader in the mortgage industry for over 20 years. Roger has personally originated over 2500 residential loans and is considered to be in the top 1% of NH Loan Officers by leading national lender United Wholesale Mortgage.