Mortgage Approval Help for Self-Employed Borrowers

by Michael from Highlands Ranch, Colorado

Ask Kate about mortgage approval for self-employed borrowers: From sole proprietors to owners of corporations, self-employed borrowers are scrutinized more carefully than salaried employees. In addition to industry-standard requirements, business owners must jump through additional hoops to convince lenders of their credit worthiness.



Let's talk about these hoops otherwise known as underwriting guidelines following self-employed Michael's question about qualifying for a mortgage.

Qualifying for a Mortgage When You're Self Employed

By Michael in Highlands Ranch, CO
Mortgage Approval Help for Self-Employed Borrowers

Hi Kate:

Thank you so much for this site. It's been extremely helpful.

What are mortgage companies and lenders looking for if you are self employed?

What if you were originally a sole proprietor and now an LLC?
Ask Kate at Get-Your-Best-Mortgage-Rate.com
Ask Kate answers: Qualifying for a Mortgage When You're Self Employed

Hi Michael,

Mortgage determination can be summed up by the three Cs of lending, Cash (income, down payment, and savings), Credit (debt ratios, credit history, and credit scores), and Collateral (the property appraisal).

Analyzing Self-Employed Income on Tax Returns

However, analyzing income for a self-employed borrower is more complex than for a salaried or hourly employee. Instead of simple W2s and a couple of recent paystubs, a minimum of 2 years of tax returns (all pages) will be required for perusal.

Income after expenses is averaged over the 2 complete tax cycles. Additionally, the income is double-checked against the current year's Profit-or-Loss statement (P&L) to verify that income is increasing, not decreasing.

For example, if loan application is made during August of 2014, the underwriter will require copies of 2012 and 2013 signed and filed tax returns along with a 2014 P&L statement, January to July.
Monica from Ohio writes... Kate, My husband and I are self-employed homeowners and have good credit. But because of the way we file our income taxes, it looks as if our income is too low and debt-to-income ratio too high. See my answer to Monica at Mortgage Approval for Self-Employed Borrowers Clearly Explained

LLCs, C-Corporations, S-Corporations, Partnerships

Paperwork intensive, at least 2 years of tax returns will be required from borrowers with LLCs (limited liability companies), C-Corporations, S-Corporations, or Partnerships, depending on their percentage of ownership in the business.

Often, owners of corporations ask why they need to supply the bank with business tax returns since, as an employee, they receive paystubs and W2s.
Case in point, an owner of a corporation writes... Kate, My husband and I never disclosed during the mortgage process that we own our corporation. We only supplied W2's and pay stubs. Did we unknowingly commit fraud? See my answer at How Mortgage Lenders Define Self Employment.
You also asked how loan approval would be affected if you transitioned from sole proprietorship to an LLC. Short and quick, a new organization midyear will increase your paperwork. Other than that, you can smooth the way by writing a letter explaining why and when you transitioned into an LLC.

Don't make the underwriter dig for explanations if income or deductions are different with the LLC. Of course, in addition to personal tax returns, include LLC paperwork for the partial year.
Use my personal planner to organize your paperwork before you make an appointment with the bank.

Calculating Debt-to-Income Ratios

Debt-to-income ratios are calculated during loan approval to determine if a borrower can afford the house payment (PITI) in addition to their other obligations, such as car and credit card payments.
PITI is short for a mortgage payment that includes not only principal and interest but also 1/12 of annual property tax and homeowner's insurance premium.
The first ratio is calculated by dividing the house payment (PITI) by the qualifying monthly income. A debt ratio of 28% to 33% is generally acceptable, depending on the program.

The second ratio is calculated by dividing the sum of all monthly debt payments, for example, house payment, car payments, and credit card payments, by the qualifying monthly income. Underwriters usually look for this debt ratio to fall between 36% and 41%, again depending on the program.

Down Payment and Loan-to-Value

The source of the down payment, the amount of down payment, and the resulting loan-to-value (LTV) ratio is looked at carefully. The underwriter will probably consider that a saved down payment vs a gift from a family member is stronger reason for issuing loan approval.

The lower the LTV, the better also. LTV is calculated by dividing the loan amount by the appraised value or purchase price, whichever is less.

For example, if a house costs $200,000 and the borrower has saved $40,000 for a down payment, the loan amount would be $160,000. Divide the loan amount of $160,000 by the purchase price of $200,000. The LTV would be 80%, and as an FYI, the borrower would not pay mortgage insurance (MI).
See Who Broke the Loan-to-Value Calculator for more information on LTV and MI.

Don't Forget Reserve Savings

Lenders also want to know that withdrawing the funds for down payment and closing costs have not drained your savings account. You should plan on being able to verify that your bank account will still have an amount equal to 2 or 3 house payments (PITI), the more the better since self-employed income is often not as steady as getting a salary.
Learn more about the pros and cons of paying off debt versus retaining your savings at Reducing Debt vs Saving Money.

Credit History and Scores

Maintaining a pristine credit record paves the way to a smooth loan approval process. But we all know life happens and even those who diligently pay bills still face financial hiccups from time to time.

Promptness with creditors should be your first emphasis but it is also important to keep credit card balances low and available credit high. In other words, even if you pay your bills on time, being maxed out on your credit cards will likely do a number on your credit scores.

Property Appraisal

A market appraisal of your home will be performed by a licensed real estate appraiser. In addition to property conditions such as health and safety factors, the property will be compared to at least 3 other nearby homes of similar size and floor plans to arrive at a value.
Learn about the difference between assessed value and appraised value at Should I Refinance My Home to Get Rid of PMI.
Hopefully this insight into mortgage approval for the self-employed borrower will help you prepare for a successful and smooth loan process.

Best wishes,

Ask Kate

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