Four years ago, when my husband and I started our initial search for a home of our own, we had no clue that it would be more difficult to get pre-approved for a mortgage when one of us was self-employed. At the time, I was working a steady 9-to-5, which was a big pro when talking to lenders, but my husband had been self-employed for 10 years.
I know it may sound shocking that mortgage lenders would favor employees over small business owners, especially considering there are 40.9 million self-employed people in the U.S. as of 2017, but it’s true. They still have this mindset that self-employed individuals are riskier than those with a salary.
And that’s why it’s so important to know the facts about getting a mortgage as a self-employed person from the start.
Have your documents ready
The best course of action is organization and preparation before looking for a mortgage when you’re self-employed. The most important documents you’ll need are at least two years of income tax reports. This is to prove that you have a steady stream of income and will be able to afford long-term payments on a home. You may also need to provide more in-depth details on your financial history, such as 1099 forms you’ve received from clients, a list of your assets and debts, a profit and loss statement from your business, balance sheets, and even a signed statement from your accountant.
In my personal experience, my husband only needed to provide two years of income tax reports, but it’s always best to be ready in case you’re asked for further documentation.
Maintain a low debt-to-income ratio
Speaking of assets and debts, it’s crucial that you maintain a low debt-to-income ratio before applying for a mortgage. What that means is you need to have a very low debt burden compared to your gross income.
To break this down a bit, here’s what the equation looks like:
Debt-to-income ratio (DTI) = total monthly debt payments / gross monthly income
The highest debt-to-income ratio you can have to qualify for a mortgage is 43 percent. When you’re self-employed though, you’ll want to have a DTI of 36 percent or below.
Don’t go overboard with tax deductions
When you’re self-employed, you may be tempted to stack up your tax deductions to get into a lower tax bracket and pay overall less income tax. That could help you come tax time, but it could actually hurt you if you’re shopping around for a mortgage.
You see, when lenders are considering you for a mortgage, they’re looking at your net income (your income after deductions but before tax). If your net income is low because of all of your deductions, you may not qualify for as much as you want. Or, you may even get a higher interest rate because you look like a risky borrower who may not earn enough to keep up with their mortgage payments.
Build a high credit rating
Credit scores have been getting a lot of attention in the past few years, but they really only matter if you intend on borrowing money. That being said, they really matter if you want to borrow money for a home and you’re self-employed. This was a big reason why my husband and I were able to get a very low interest rate on our current mortgage. Our credit scores were both in the high 700s.
In order to make sure you’re building up a solid credit rating, make sure you’re always paying your debts on time, don’t carry a balance on your credit cards, make sure you’re not spending more than 35 percent of your available credit, and check your credit reports regularly for any errors or inconsistencies.
Shop around for the best mortgage rate
You may be tempted to just walk into your current bank and ask for a mortgage. Do not do this! They will give you a rate, that’s for sure, but it may not be the best one available.
A good starting point is to see what the current mortgage rates advertised by major financial institutions are. With this knowledge in your back pocket, shop around. You can either do this yourself by going to lenders individually (just beware, each time a lender pulls your credit, your credit score will get dinged). Or you can use a mortgage broker to shop around for you. Before working with a mortgage broker, make sure you know how they are being compensated. Sometimes you as the homebuyer will have to pay a fee, but sometimes they’re solely compensated by the lender when you lock down a mortgage. And don’t forget to hit up your local credit unions. In general, they’re more likely to work with self-employed individuals than the big banks.
If I can do it, So can you!
Even though it wasn’t easy for my husband and I to get a mortgage when he was self-employed, our story does have a happy ending. We used a mortgage broker to find a great rate for us and have been in our home for a year and a half already. So, take it from me, if we can do it by making sure we have good credit ratings, low debt-to-income ratios, and having all the proper documentation ready to go, then there’s no reason you can’t follow in our footsteps!