Lenders need to verify your income beyond a reasonable doubt. They do this with paystubs and W-2s. What if you don’t have those items because you work for yourself or are a contractor? Are you out of luck?
Luckily, the answer is ‘no.’ You can still get a mortgage with self-employed income. However, different rules apply to you. Because you don’t have paystubs and W-2s, the lender will need more verification of your income. They need to make sure it’s legitimate and that it’s consistent – these are two very important factors.
Two Years is Crucial
The first step is the time you receive your self-employment income. Working for yourself for six months isn’t going to get you an approval. The magic number is 2 years – that’s how long lenders want to see you self-employed.
Why two years? It shows consistency and legitimacy. If they took your income after just six months, how are they to know if you’ll be successful? You have not even seen the ups and downs that an entire year can create yet. Two years is the time that things settle down and you can show a pattern of the ups and downs throughout your business cycle.
Calculating Self-Employed Income
Once you prove your job is legitimate, you need to determine how to prove your income. It starts with your tax returns. This is the easiest way to prove your income. However, it can also be the most damaging. As a business owner, chances are that you claim expenses that take away from your income. Your lender must take your net income claimed on your taxes. If you claim too many expenses, it can hurt your chances of getting a loan. If you know you’ll apply for a mortgage in the next couple of years, you may want to lay off the write-offs to keep your self-employed income looking as high as possible.
So what do lenders need to calculate your income? They’ll need the following:
- 2 years of individual tax returns
- All schedules of your tax returns
- W-2s if you pay yourself
- 2 years of business tax returns
- All schedules of your business tax returns
- A Profit & Loss Statement for the year up to the current date
The lender will then take an average of your income. A 2-year average is best because again, it shows the ups and downs of your income. They will collaborate with your YTD P&L to make sure you currently make the same or nearly the same income that you claimed on your taxes.
Less Than 2-Year Self Employment
What if you have been self-employed for less than 2 years? You may be able to use your income, but only if you have a history in the same field. Say for example, you opened your own accounting firm. You have owned it for 1 year. However, before opening your own firm, you worked for another firm for 4 years. That shows the lender that you have the experience in the industry. Your likelihood of success is higher knowing that you have that experience.
In this case, a lender may take your 1-year income. However, if you did not have that experience as an accountant working for someone else before, you wouldn’t get that luxury. The lender needs proof that you know what it takes to be a successful accountant today.
Taking the Average
Basically, lenders will take an average of your 2-year income. Let’s say you claimed $75,000 income 2 years ago and $100,000 last year. The lender cannot use the $100,000 as your average income. Instead, they will use the average of the two years.
Here’s how that looks:
- If the lender used just last year’s income, you would have an average monthly income of $8,333
- If the lender used an average of the last 2 years’ of income, you would have an average monthly income of $7,292
While the latter income is lower, it’s more realistic of what you should base your mortgage payment on. If the lender used the higher $8,333, you might take on a mortgage you cannot comfortably afford year-round. The average helps account for the ups and downs your income likely experiences, ensuring that you can afford your mortgage payment no matter the time of year.
Self-employed income is complicated and takes more work to verify than employer-based income. It’s not impossible to get a mortgage, it may just take more time and more verification. The lender must verify beyond a reasonable doubt that you actually make the income you claim. They may ask for several bank statements, a business license, or letter from your CPA stating that you are self-employed and make what you claim. All of these steps are to make sure that you truly can afford the loan you asked to receive.