The number of self-employed workers in the U.S. is rising, but showing proof of that income can be a challenge on a mortgage application.
The U.S. Bureau of Labor Statistics, or BLS, reported there were 9.6 million self-employed workers in 2016. The BLS estimates that number to rise to 10.3 million self-employed workers by 2026, or a 7.9 percent growth rate.
When you work for an employer, they provide a W-2 form that includes the wages paid to you, amount of Social Security taxes withheld and other details about your income.
Businesses who contract with self-employed workers, however, file a different document with the IRS called the Form 1099-MISC. It reports any payments of $600 or more that a business makes to a person who’s not a regular employee or who operates an unincorporated business for a service, according to the IRS.
If you’re self-employed and want to buy a home, here are some key things to know before applying for a mortgage.
Have your paperwork together
The mortgage process requires a lot of documentation and even more paperwork for self-employed workers. Instead of the standard federal tax return of one year, expect to provide at least two years of returns to show consistent income, especially if you’re a contractor who receives bonuses or commissions. The documentation burden is greater when you work for yourself, so have a list of both your assets (think retirement and brokerage accounts) and liabilities (like child support or alimony payments) handy.
Small business owners will likely need to provide a profit and loss statement, in addition to a 1099 form. You may also need a signed letter from your accountant that states you’re still in business.
“Proof of income is the biggest hurdle that self-employed borrowers encounter during the mortgage application process,” says Greg McBride, CFA, Bankrate’s chief financial analyst. “Unlike a salaried worker with consistent pay stubs and W-2s, self-employment income can be lumpy with big swings from one year to the next. Keep in mind that if your business is showing a loss on tax returns, that’s also a loss for loan qualification purposes.”
Don’t assume it will be harder to get approved
Self-employed borrowers undergo the same process when they are applying for a mortgage as people with a wage or salary. The requirements are a little more stringent with more documentation as lenders and banks want borrowers to demonstrate income stability, says Richard Liu, a mortgage consultant with C2 Financial Corp., a San Diego-based mortgage brokerage.
One common misconception among self-employed borrowers is that their gross income or revenue is used. Instead, the net income or revenue — minus expenses — is used to determine how much they can borrow.
“Generally, monthly income used to qualify is derived from a two-year average,” Liu says. “If the most recent year’s income is lower than the prior year, then only the most recent year’s income is used.”
Don’t mix business with personal
Small business owners should never mix business expenses with personal ones because it can impact your credit score. It can also be harder to establish business profit and loss.
Open a business bank account and charge work-related items such as supplies, client dinners and other expenses through a business debit or credit card. It will be easier for a lender to see and evaluate all your liabilities.
Keep your credit picture stable
The interest rate you receive for your mortgage is based, in part, on your credit score. A higher credit score means you’ll qualify for lower mortgage rates, which can save you thousands of dollars over the life of your loan.
Your first step: check your credit score and credit reports. Fix any reporting errors you find, and work with your lender on ways to boost your score like lowering your credit utilization rate or consolidating high-interest debt with a personal loan if you’re not buying a home right away.
You also shouldn’t close any credit card accounts – even if you’ve paid them off – because the length of time you’ve had open lines of credit factors into your credit score, and closing accounts can lower that score.
Your down payment amount and debt-to-income ratio also impact your credit score. Avoid making any large purchases before your loan closes because it could impact your credit score and increase your interest rate. In other words, buy household appliances, furniture or other big-ticket items after you sign the paperwork.