When you apply for a mortgage, the lender will check your monthly income to make sure you can afford to make regular house payments.
Freelancers, business owners, and other independent contractors are considered “self-employed.” Their income is determined by profit-and-loss statements, 1099s, and tax returns.
Fortunately, that won’t exclude you from getting a mortgage. It’s possible to get approved with self-employed income as long as you know what lenders are looking for.
Getting approved for a mortgage can be more challenging when you’re self-employed. Unlike salaried employees who receive regular paychecks, self-employed individuals need to provide additional documentation to verify their income.
Lenders want to see that you have steady, reliable income in order to qualify for a mortgage. By learning how lenders calculate income for the self-employed, you’ll be better prepared when applying for a home loan.
What Counts as Self-Employed Income?
You are considered self-employed if you:
- Own your own business
- Work as an independent contractor or freelancer
- Are a partner in a business partnership
- Receive income from commissions, investments, or rentals
Common sources of self-employment income include:
- Revenue from your business
- Consulting or freelance fees
- Commission-based pay
- Rental income from investment properties
- Dividends and interest
The income must be steady and continuing in order for a lender to consider it qualified income. One-time payments or income from a contract that expired would not count.
Minimum Length of Self-Employment
Most lenders require you to have been self-employed for at least 2 years in order to use that income to qualify for a mortgage. This demonstrates that the income is stable.
In some cases, only 1 year of self-employment may be acceptable if you have solid experience in the same field prior to starting your business.
Documentation Needed
As a self-employed borrower. be prepared to provide the following documentation
- Personal tax returns – Minimum 2 years, including all schedules
- Business tax returns – Such as Schedule C, Schedule E, 1120s, 1065s
- 1099 forms documenting your self-employment income
- Profit and loss statements – For current year to date
- Bank statements – To show income deposits and cash flow
This documentation allows the lender to fully analyze your income from self-employment. Make sure to provide explanations for any irregularities or discrepancies.
Gross vs. Net Income
Lenders will look at your net income, not your gross revenue or sales. Net income is the profit left after deducting all business expenses.
For example:
- Gross sales revenue: $100,000
- Business expenses: $30,000
- Net income: $70,000
$70,000 would be the income amount used for mortgage qualification. Business expenses have already been deducted.
How Lenders Calculate Self-Employed Income
There are a few methods lenders may use to calculate your income, including:
Two Year Average
Total net income from the last two years is added together, then divided by 24 months. This determines your average monthly income.
For example:
- Year 1 net income: $60,000
- Year 2 net income: $80,000
- Total: $140,000
- $140,000 / 24 = $5,833 average monthly income
Analyzing Tax Returns
Lenders will review your complete tax returns, including schedules like Schedule C (for sole proprietorship income). The adjusted gross income on your 1040 provides your annual net income amount.
Reviewing Bank Statements
Deposits into your business bank account may be analyzed to confirm your income is consistent with amounts reported on tax returns. Large discrepancies could raise red flags.
Declining Income
If your income has declined significantly year-to-year, this could impact your approval chances. Lenders look for stable income that is likely to continue.
Significant income declines may require a written explanation or additional documentation to support the changes. Or the lender may base approval on your lowest income year.
Tips for Self-Employed Borrowers
Follow these tips when applying for a mortgage as a self-employed borrower:
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Maintain low debt ratios – Keep credit card balances and other debts low compared to your income. This helps offset the higher risk of self-employment income.
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Keep business and personal finances separate – If you’ve commingled finances, a CPA can assist in separating prior to getting a mortgage.
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Review tax returns – Look for red flags like excessive deductions and be prepared to explain if needed.
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Get your documents in early – Provide all required paperwork upfront for the loan officer to review.
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Consider an income review – Some lenders offer upfront income verification to catch issues early.
With proper documentation and financial prudence, being self-employed shouldn’t hurt your chances of getting approved. By understanding how lenders evaluate your income, you can take steps to boost your qualifications.
Frequently Asked Questions
How is my mortgage eligibility affected if I’m self-employed?
As a self-employed borrower, you’ll need to provide more documentation to verify your income for the past 2 years. This includes personal and business tax returns. The lender needs to confirm your income is steady.
What methods do mortgage lenders use to calculate self-employed income?
Common methods include looking at your net income from tax returns, averaging your income over 2 years, analyzing business bank statement deposits, and comparing your current year profit and loss to prior years.
My income declined last year. Will this hurt my approval chances?
If your income decreased significantly last year, be prepared to explain why and provide documentation to support the change. Lenders want to see stable earnings unlikely to change in the next 3 years. A large decline could impact your approval odds or loan amount.
What expenses get deducted from self-employed income for mortgage calculation?
Lenders look at your net income after deducting valid business expenses. This includes costs like supplies, payroll, rent, utilities, and other typical operating expenses. Non-recurring or excessive expenses may require explanation.
Can I get a mortgage if I’ve only been self-employed for 1 year?
Most lenders require 2 years of self-employment income to qualify. But 1 year may be acceptable with a strong history in the same field prior to starting your business. Stability and continuity are key.
The Bottom Line
As a self-employed mortgage applicant, take steps to provide a complete picture of your income and minimize red flags on tax returns. With proper documentation, most lenders are willing to approve loans for borrowers who are self-employed. Pay stubs may not tell the full story of your earnings, but your tax returns will.
Using business accounts for your down payment and closing costs
In some cases, you can use funds from your business accounts from your down payment.
Sometimes, though, the underwriter will ask you for a letter from your certified public accountant (CPA) saying that taking money from the business won’t jeopardize the ongoing health of the business.
Your CPA may or may not be willing to write this letter.
The underwriter wants to verify your business won’t be short on cash and be forced to take out loans or shut its doors due to lack of funds. After all, your business is the source of your income, and if your income stream stops, you may default on your loan.
Any business funds used for closing costs or the down payment on a home should be excess money that the business will not need for the foreseeable future.
Two-year minimum for self-employment
Before calculating your income, a lender will make sure you’ve been in business, in a self-employed capacity, for at least two years.
How do you prove that? You can provide a copy of your business license, but lenders will also want to see two years of federal filed income taxes, signed and dated.
Lenders define a self-employed borrower as anyone who receives more than 25 percent of their income in non-salaried pay. This definition incorporates borrowers who work on commission or earn bonuses along with a regular salary.