Mortgages and the Self Employed

You are self-employed and are looking to purchase a home or refinance your mortgage. You have heard 

horror stories regarding reams of paperwork and underwriters who wanted two pints of blood in order to approve a loan application. As a matter of fact, you have held off purchasing a home for years because you thought verifying your income may be difficult or impossible.

In this article we will investigate one of the more complex areas of real estate finance. Hopefully we will help dispel some myths and make the process easier for everyone.

Who is self-employed (SE)? For underwriting purposes, someone is considered SE if they own 25% or more of the entity which provides their income. For example, if someone is a sole proprietor (such as a real estate agent)–they are SE. If someone owns at least 25% of a corporation (such as a restaurant) or partnership (such as a law firm), they are SE.

Why is self-employment important? SE is important from an underwriting standpoint because the income derived from SE varies (i.e. variable income). It also is more difficult to calculate than salaried income. This gives rise to two important underwriting concepts–

1. Two year average. The income of a SE applicant is derived by taking a minimum two-year average. For example, if one has earned $50,000 in 2010 and $70,000 in 2011–the average annual income used by an underwriter would be $60,000. Many loan programs will not consider applicants who have been SE less than two years.

2. Net, not gross income. The income used to qualify an applicant is the net income derived from the business. If one owns a restaurant which grosses $2 million annually, this is not relevant because the net of the business may be $30,000 annually. Generally, salary derived from the business can be used (it is still averaged) as long as the salary is supported by the cash flow of the business. In the case of a sole-proprietorship, it is the “net” of the Schedule C which is important.

But what about all those “phantom” write-offs? If you are telling the IRS that it is a business expense, then it is a business expense–though some “non-cash” items such as depreciation may be added to the income.

What should I bring to application? In addition to the “normal” documents,bring two years complete and signed federal tax returns and a profit and loss current through the previous quarter, unless you are applying in the 1st quarter of the year in which case the returns will suffice. If there is a corporation or partnership involved, bring these returns as well.

What about no-income programs? It is true that many who are SE have heard of programs that require no documentation of income. However, these programs are few and far between in the wake of the financial crisis and recession. If you find such a program, it is likely to require a much larger down payment and/or significantly higher rates and fees. You are also required by law to be accurate with regard to the question on the application which asks for your income, regardless of the documentation method.