When you apply for a mortgage, your lender will determine your ability to repay the loan by verifying your income. For employed individuals, it’s almost straightforward since you can use recent tax returns, pay stubs, and W-2s. But what happens if you’re self-employed?
Whether you’re a small business owner, gig worker, freelancer, or independent contractor, you’re probably wondering how you can calculate your income for a mortgage. In this post, you’ll learn how to calculate self-employment income to know whether you will purchase or refinance a property.
Who are Considered Self-Employed Individuals?
A self-employed person is anyone who works for themselves rather than for a company and typically reports self-employment income. However, you must prove that you’ve been self-employed for at least two years.
25% or More Ownership in a Business
You’re considered self-employed if you own 25% or more of a business. However, mortgage lenders will require you to provide additional documentation for the business to evaluate qualifying income.
As a sole proprietor, you’ll report your business income on Schedule C of your tax returns. If you operate under a partnership, corporation, or S corporation, you’ll file your business tax returns and report the company on Schedule E of your personal tax returns.
Freelancers
A freelancer is a self-employed person who earns money by providing services to multiple clients, typically for a short term. While freelancers can take on contract work from companies and organizations, they are still considered self-employed.
Contract Workers
A contract worker, also known as an independent contractor or 1099 earner, is one who enters into a contractual agreement with a company or business to provide specific services for a given period of time in exchange for a fee. Though they sign a contract, they remain self-employed individuals.
Seasonal Workers
As the name suggests, seasonal workers provide their services to meet a company’s temporary needs at certain times of the year. This includes businesses that operate in peak seasons and remain closed during slow seasons.
Gig and Side Job Workers
Gig workers are independent contractors and freelancers who work on short-term projects for various clients. They normally enter into formal agreements with in-demand companies to offer services for pay.
Self-employed Gross vs. Net Income
For self-employed individuals, gross income is your income from all sources before taxes and other deductions. This can include your wage from your employer, rental income, dividends, and compensation from services before retirement contributions and health insurance premiums are deducted.
On the other hand, net income or take-home pay is the amount of money you receive after taxes and deductions have been taken out from your gross income. Most W-2 employees receive their net income in a paycheck with taxes already deducted, while self-employed people receive gross pay, which they are responsible for paying their own taxes.
Are There Mortgage Loans Specifically for Self-Employed Individuals?
Yes, there is a wide range of mortgage products for self-employed borrowers. The most popular loan options include:
- Bank Statement Loan: You can get a mortgage using your bank statement rather than tax returns, pay stubs, or W-2s.
- Asset Qualifier Home Loan: If you have a lot of assets, you can use them to secure a mortgage loan.
- Investor Cash Flow Home Loan: This is ideal for real estate investors as they can use the cash flow from their property to qualify for a mortgage,
- Jumbo Loan: A loan product for homeowners looking to purchase property exceeding the conforming limits set by the Federal Housing Agency.
- 1099 Income Loan: Freelancers and independent contractors can use 1099 forms to pursue their dream of homeownership.
- Foreign National Program: Non-citizens can purchase a house or refinance in the U.S. with a foreign national program.
You can get the above self-employed mortgage through Angel Oak Mortgage Solutions. Simply submit an online form to inquire about the loan product you’re looking to get.
What Type of Income Will Mortgage Lenders Consider?
When applying for a mortgage, lenders will need proof of steady income to ensure you can manage your monthly payments without defaulting. Depending on your situation, lenders generally look at different sources of income, including:
- Self-employment Income: This is arguably the most popular type of income that lenders look at when evaluating your eligibility for a loan. You’ll need to provide alternative documentation, such as bank statements, profit and loss financial statements, or liquid assets, as proof of income instead of using pay stubs, tax returns, and W-2s.
- Investment Income: If your investments earn you interest and dividends, lenders will want to see that, too. You must provide documentation showing you have received interest payments and dividends from your investments over a specific period, typically two years. Lenders will use the information to determine if you qualify for a mortgage loan.
- Rental or Property Income: For real estate investors with rental property, lenders will want to see your rental income. You must show proof of rental income in your tax returns.
- Spousal or Survivor’s Benefits: Mortgage lenders also consider spousal or survivor’s benefits as sources of income that can help you qualify for a home loan. If you want to use this type of income to secure a mortgage, you must prove that you’ll receive these benefits for the next three years.
- Retirement Income: If you’re using your retirement accounts to apply for a mortgage loan, your lender will need to prove that your payments will continue for at least three years from the date of your mortgage. Most lenders use 70% of these accounts to evaluate your eligibility since they can drop in value.
How to Calculate Self-Employed Income
Most mortgage lenders want to see the stability of your income and at least two years of self-employment income.
To calculate your self-employment income for a mortgage application, follow these simple steps:
- Find your net income from Schedule C on your tax returns for the two most recent years
- Add the two figures together
- Divide the result by 24
For example, if your net income for year one was $95,000 and year two $98,000, the income for a qualifying mortgage will be $95,000 + $98,000 = 193,000 divided by 24. The result is $ 8,041 per month.
It’s important to note that if your income declines year after year, lenders may be hesitant to loan you because it could indicate a falling business.
What Else Can Self-Employed Individuals Show as Proof of Income?
Other ways you can prove your income as a self-employed borrower is by providing:
- Bank Statements: Your bank statements can serve as proof of income when applying for a mortgage. Lenders usually require 12 to 24 months’ worth of bank statements. If you use one account for personal and business banking, you’ll need to highlight all the business-related payments.
- Profit and Loss Statements: A profit and loss statement shows all your total revenue, business expenses, and profits over a given period of time. You’ll not only use it as proof of income to qualify for a loan program but also to help make better business decisions.
- 1099 Forms: This is a tax form given to freelancers and independent contractors. The 1099 form contains the self-employed individuals’ tax identification number or SSN and the amount paid to you by the client, which is why it can serve as proof of income.
- Self-Employed Pay Stubs: You can also create pay stubs if you’re self-employed using a stub generator and use them as proof of income. For a self-employed pay stub to be considered legally valid, it must include gross pay, deductions like Medicare and Social Security, state and local taxes, and net pay.
Other Things You Need to Consider When Calculating Self-Employed Income
Aspiring home buyers should keep a few things in mind when calculating self-employment income. These are the details that self-employed applicants should keep in mind.
Taking into Account Gross Income and Expenses
Your gross income reflects the total revenue your business generates. However, mortgage companies want to know how much you retain after business expenses. You will have to deduct various expenses from your gross income to arrive at your total personal income.
Including Year-to-Year Income Variations
Not every business makes consistent sales each year. Some businesses have inconsistent revenue each year, which can make a mortgage lending company feel unsure about approving your application. A clear uptrend in how much money your company makes and retains can demonstrate financial responsibility and increase the chances of a successful mortgage application.
Factoring in Depreciation and Other Non-Cash Deductions
Business owners with depreciating assets like property and vehicles have to take those into consideration when calculating their self-employment income. Depreciation results in a lower tax bill. It’s important to show these tax deductions during the mortgage application process, even though they will reduce your taxable income. A good credit score can still put you in a position to get good financing from a lender.
Typical Documentation Required for Reporting Self-Employed Income
Lenders review several documents to determine your monthly income, so your reduced taxable income doesn’t hold you back from financing. These are some of the documents a loan officer may require.
Federal Tax Returns
While traditional employees receive W-2 forms, independent contractors usually receive 1099 forms. The 1099 form contains the self-employed individuals’ tax identification number or SSN and the amount paid to you by the client, which is why it can serve as proof of income.
Profit and Loss Statements
A profit and loss statement shows all your total revenue, business expenses, and profits over a given period of time. You’ll not only use it as proof of income to qualify for a loan program but also to help make better business decisions.
Bank Statements
Your bank statements can serve as proof of income when applying for a mortgage. Lenders usually require 12 to 24 months’ worth of bank statements. If you use one account for personal and business banking, you’ll need to highlight all the business-related payments. Lenders can use this information to assess if you make enough income to receive one of their bank statement loans.
Self-Employed Pay Stubs
You can also create pay stubs if you’re self-employed using a stub generator and use them as proof of income. For a self-employed pay stub to be considered legally valid, it must include gross pay, deductions like Medicare Social Security, state and local taxes, and net pay.
Business Financial Statements
Business owners can provide their companies’ financial statements to help lenders assess what to offer. You can avoid higher interest rates if your company has strong financials which feature good debt management.
Common Pitfalls to Avoid When Reporting Self-Employed Income
Self-employed income can make it easier to obtain financial products. You can access capital even if Fannie Mae and Freddie Mac look the other way. However, you should avoid these common mistakes when assembling your IRS form, bank account statements, and other information as you report your net income.
Under-Reporting Income
Under-reporting your net profit will result in a higher debt-to-income ratio, which will hurt your chances of qualifying for a loan. Even if you get approved, your mortgage broker will likely give you a higher interest rate. It’s not the worst-case scenario, but you are missing out on extra savings by under-reporting your income.
Over-Reporting Income
While it’s bad to under-report your income, it’s much worse to over-report your financial health. Your loan will get rejected if the lender finds out, and you can face legal action if you overstate how much you earn. Painting the wrong impression about your financial situation can result in a lower DTI ratio, which would increase your chances of getting approved and result in a lower rate. While it’s good to achieve that with your actual income, doing so with an inflated number could get you in trouble.
Ignoring Tax Returns and Other Official Documents
You have to provide all federal tax returns from the past 1-2 years, depending on the lender’s requirements. Not presenting all of your documents will result in inaccurate information. This scenario can prolong the application process and result in less favorable monthly mortgage payments.
Tips to Secure Better Rates and Terms
A sufficient income is one stepping stone toward securing competitive rates and terms for your loan. These are some of the other things you can do to improve your chances of getting approved.
Shop Around
You can compare rates and terms from various lenders instead of only submitting one application. Reviewing your options can help you find a better deal and negotiate better terms from another mortgage lender. You shouldn’t do business with a lender just because you have experience working with them. Expanding your horizons can save you a lot of money in the long run.
Build Your Credit Score
A higher credit score helps you qualify for loans and receive better terms. A FICO score of 700 or higher will help you qualify for most loans. However, you can get a Fannie Mae or a Freddie Mac loan if you have a 620 FICO score and fulfill the other requirements. You can use many strategies to build credit, but it mostly boils down to making on-time payments and playing the long game.
Pay Off Debt
You can make the minimum monthly payment and have a good credit history. However, paying off more debt reduces interest accumulation while improving your credit utilization ratio. This ratio makes up 30% of your FICO score. Cutting down your debt will not only improve your credit utilization ratio but also result in a more favorable DTI ratio. Mortgage lenders will assess your DTI ratio when determining if you qualify for a loan.
