When you’re employed, it’s easy to apply for a loan. Simply submit an application with the lender, provide a copy of your most recent pay stubs, and you’re all set. But getting a loan as a self-employed borrower is another story since there are no pay stubs or W2 forms. Self employed individuals can still secure the funds they need, but it involves extra steps. You need to understand what lenders look for and what documents they’ll accept as proof of income before applying.
In this guide, you’ll learn about several loan options available to self-employed borrowers and how to increase your approval odds.
Can Self Employed Individuals Get A Loan?
Yes, it’s possible to get a loan if you’re self employed. However, it can be more challenging to qualify for funding with most traditional lenders, including banks and credit unions. Once you’re familiar with the extra steps involved, qualifying for a personal loan will become easier.
Why It’s Trickier To Get A Loan if You are Self Employed
Lenders incur risk with each loan they provide. Loan defaults hurt a lender’s profitability, and enough of them can create a financial mess. Lenders use several safeguards to reduce the likelihood of defaults. Financial institutions want reassurance that borrowers can afford to repay what they borrow. It’s equally important that the borrower makes on-time monthly loan payments. Lenders will look at several details before giving a loan, but credit history and income stand out.
A lender can easily access your credit report via a credit pull. Income is the next piece of information lenders need, but this can get complicated for self employed workers. Lenders have an easier time telling if a salaried worker can afford a loan since their wages are more predictable. However, self employed individuals tend to have less consistency and are more difficult to predict.
There are no pay stubs or W-2 forms to assess, so lenders may ask for bank statements to estimate earnings from the last three months. In addition, some lenders will require you to provide the most recent tax returns when you apply.
What Lenders Generally Look For
A lender is a gatekeeper between you and a lump sum of cash. By understanding what lenders want, you can improve your loan application and have a greater chance of getting approved for financing. Most lenders will ask for the following details if you are applying for a loan as a self employed individual:
Income Stability
Your income should be relatively stable to have the best chance of qualifying for business financing. An occasional dip in your income isn’t necessarily a deal-breaker, but lenders prefer applicants with increasing revenues. Monthly loan payments will consistently show up, even if income is not stable. Income stability reduces a lender’s risk and can result in favorable rates and terms.
Nature Of Your Self-employment
It’s also ideal if you’ve worked in the same industry for two or more years. A shorter work history in a particular sector could be a red flag to lenders and subject you to more stringent qualification criteria. On the other hand, bouncing around too much will make lenders question the viability of your current income.
Financial Strength Of Your Business/Source Of Income
Do you have cash reserves to smooth out income gaps or cover unexpected expenses? If not, you could be viewed as risky to the lender and receive a higher interest rate. Building up an emergency fund to cover six months of expenses can improve your chances of getting approved and offer resistance against financial challenges.
Ability To Generate Sufficient Income In The Future
Are your revenues trending upward or downward? Lenders want to know that your company will be able to generate sufficient income in the future, and a continuous dip in earnings could indicate the inability to do so. You could still get a loan, but lenders may not offer you as much capital.
Typical Loan Requirements For Self Employed
Each lender has its own qualification criteria. Reviewing various lenders will help you submit a loan application with great terms and a higher chance of approval. You can expect to see requirements in these areas to secure funding:
Your Credit Score
The lender will pull your credit report and score to gauge your creditworthiness and determine if you’re a good fit for a loan. A bad credit score doesn’t mean you’ll be denied financing, but the interest rate you receive will likely be higher. You might also have to settle for a lower loan amount.
Verification Documents
Lenders will ask you for bills under your name or any other documents that can prove your identity or personal contact information and address. They will also require you to share your social security number.
Pay Stubs
If your client(s) remit payment through a standard payroll processing system, you may be able to access pay stubs. Print them off and provide them to the lender as proof of income if allowed. Of course, you can prove your income with other methods, but if you have pay stubs, don’t hesitate to use them.
Bank Statements
Some lenders allow you to use bank statements as proof of income. The account you use should display consistent deposits from income earned in your business. Lenders may look over several months of previous bank statements instead of stopping at your most recent document.
Profit And Loss Statements
Profit and loss statements provide a closer look at your income and expenses. If you’re spending more than what’s coming in, the lender may be reluctant to offer to finance or provide unfavorable loan terms to hedge against the risk of default.
Debt-to-Income Ratio
When applying for a personal loan, your debt-to-income ratio looms large. This ratio gives lenders insight into how much of your income already gets allocated to debt payments. For example, if you make $5,000 per month and pay $2,000 per month in debt (i.e., mortgage and other loans), you have a 40% debt-to-income ratio. Many lenders will work with borrowers who have debt-to-income ratios below 43%, but they prefer debt-to-income ratios below 36%.
You can improve your debt-to-income ratio by earning more income or paying more of your debt. Eliminating credit card balances will impact your debt-to-income ratio. When applying for a personal loan, you can increase the loan’s duration to reduce your monthly payments. Lower monthly payments on your loans will put your debt-to-income ratio in a more favorable position.
Personal Tax Returns, including Schedule C, Schedule SE, Form 1120S or K-1, and 1099s
Your personal tax returns reflect your earnings in the prior year. Lenders often request returns for the past two years to determine if your income is trending upward – a significant drop could indicate mounting financial issues and a red flag. If income follows the current trend and continues to fall, it could weaken the borrower’s ability to make loan payments. Most online lenders and financial institutions don’t want to take that risk.
Collateral
Secured loan products for self employed individuals require some form of collateral. This could include a valuable item, like a car or jewelry. While getting approved for a secured loan is generally easier, they’re risky, and you could lose your collateral if you default on the loan agreement. Granted, collateral could be your only path to a loan, and these financial products have lower interest rates. Taking more risk off the lender’s shoulders will help you get better rates and terms.
Type of Loans For Self employed
Self employed workers can select from several loans. We compiled a list of loan opportunities that you may qualify for:
SBA Microloans
SBA Microloans are available through SBA-approved lenders. They’re backed by the SBA and cater to business owners who struggle to qualify for funding elsewhere. Loans are limited to $50,000, come with a six-year term, and can be used for most business expenses, excluding real estate acquisitions and debt repayment. You can find loans with quicker funding and easier requirements, but SBA microloans have some of the most competitive rates available. These loans usually require collateral to support a personal guarantee to repay the loan.
Business Credit Cards and Lines of Credit
There are several business financing options available to self employed borrowers. Some offer cashback rewards, travel points, and other incentives, but they’re generally reserved for consumers with excellent credit.
A business line of credit is another viable option, but you’ll typically need a few years of business experience to qualify. You can pull from a pool of funds on an as-needed basis, and you’ll only pay interest on the amount you borrow. After you pay off the balance, you don’t have to reapply to borrow funds. You can borrow against your credit limit again and pay it back over time. Credit cards have higher interest rates, so you should let balances linger for too long. You can also save money by using a new business credit card and taking advantage of the introductory 0% APR rate. Some cards don’t accumulate interest for the first 6-18 months.
Payday Loans
Payday loans don’t have credit scores or debt-to-income ratio requirements. Fewer requirements make funds easier to obtain, but you should only consider payday loans as a last resort if you need fast cash. They come with steep interest rates, sometimes triple digits, and are often due by your next payday or within two weeks of taking out the loan. And if you’re unable to remit payment on the due date, you’ll rack up even more fees. You could end up paying more in fees and interest than the loan’s original value. A short-term working capital loan is the better choice. This loan helps you cover immediate expenses without the fees and high-interest rates you’ll find with payday loans.
Co-signed Loans
If your credit score isn’t up to par or you’re new to the business world, a co-signer could strengthen your chances of getting approved for a personal loan. While it’s not allowed by all lenders, a co-signed loan may be a viable option to secure financing with competitive terms since the lender will have the reassurance that a second party is responsible for the loan if you fall behind on payments. The co-signer inherits a significant risk since they become responsible for the loan if you can’t make payments. You’ll have to find someone who trusts you enough to incur that risk, and even then, you should explain to that person how you will keep up with monthly loan payments.
Equity Financing
Equity financing is a strategy that turns a percentage of your company into cash. You can sell a position in your company as if it were a stock. While you will have to give a percentage of revenue to your equity holder, and the position will get more expensive to buy back as your company grows, someone else will become invested in your company. Some equity holders will help promote your company and help you explore new opportunities.
Home Equity Loans Or Cash-Out Refinances
Do you have a sizable amount of equity built up in your home? You can convert a portion of it to cash through a home equity loan or cash-out refinance, and the cost of borrowing on these loan products could be low. While you’ll get a low rate, your home becomes collateral, and a cash-out refinance or home equity loan will increase the pressure on your finances. You will risk foreclosure if you fall behind on payments. Collateral reduces your risk, but not everyone feels comfortable using their home as collateral for another loan.
