Being self-employed as a freelancer or contractor brings enormous flexibility for when, where, and how you earn money. These qualities also establish an important responsibility to carefully organize and manage your business documents. For Community First Credit Union, the information about your self-employment income, taxes, and operations are vital to the home mortgage process and necessary as you prepare your mortgage application.
Homeownership is a symbol of stability for both the borrower and the lender. Lenders depend on reliable borrower income to reduce their exposure to risk. For borrowers, a mortgage is a path toward homeownership when they do not have enough cash to purchase a home outright at closing. You can get a mortgage and become a homeowner even if you are self-employed. Let’s talk about how that process works.
What is the difference between a W-2 employee vs. being self-employed?
A W-2 employee is an individual who receives a regular wage and other benefits like healthcare insurance from their employer. The employer withholds income tax from their paychecks and has control over the type of work they do, and when they do it.
If you are self-employed, you will receive a 1099 tax form from clients when their payments to you add up to more than $600 a year. Self-employed also means you have a client contract in place, and no income tax is withheld from client payments. Because you are self-employed, you have more control over the hours you work. But you are also responsible for:
Lastly, lenders define you as self-employed if you own 25% or more of your business. There is an important distinction between mortgage qualifying income and taxable income, so your tax returns are critical supporting documents when the lender is considering your application.
How do you prove your creditworthiness as a borrower?
As someone who is self-employed, getting approved for a mortgage can take a little more work compared to someone who is a W-2 employee. But don’t worry, it is possible! Lenders just need to know that you are a good risk. Therefore, you will have to prove your creditworthiness to them before they will approve you.
When lenders review your mortgage application, they will be looking for the following:
- Proof of your income stability - Being an independent contractor means your income can fluctuate and your lender needs to see it is stable enough to sustain a mortgage payment. Generally, lenders are looking for a clearly documented 2-year history of self-employment income.
- The type of business you have - What is your area of expertise and is it sustainable?
- Your future business growth - What is the outlook for your field? Does it stand to grow in the next five to ten years? Do you already have a proven track record of growth?
- Your debt-to-income ratio - This is used to calculate how much debt you have compared to how much income you have. For example, if your DTI is 10%, that means 10% of your income each month goes toward paying debts. Most lenders are looking for a DTI of less than 43%.
- Your credit history - How long have you had credit, and have you made your payments on time? Do you have too much credit, or not enough?
What Documents Does Your Lender Need?
Your lender will want to see a lot of documentation before they will approve you for a mortgage. You should be prepared to provide them with:
- Letters or emails from your current clients.
- A letter from your CPA.
- Copies of your business licenses.
- Documentation from any organizations you are a member of.
- Personal tax returns.
- A profit and loss statement.
- Bank statements.
All of these items help prove that you have a legitimate business and are genuinely self-employed.
How does the current housing market impact the process?
If you are trying to buy a home when the median prices are extremely high, you may not qualify for a mortgage of that amount. But that does not mean you can’t buy a house. It just means you need to keep an open mind and prepare a bit further. High prices can be overcome with enough cash to cover a larger down payment. Another approach is to get your DTI as low as possible.
Borrower A creditworthiness vs. Borrower B creditworthiness
Let’s take a look at two different borrowers and their goals to buy homes as self-employed, independent contractors:
Borrower A has been self-employed for ten years. She has a local business license and a DBA. She has 20 clients, and most have worked with her steadily for the past five years. She has bank statements that show a continuous increase in her income over the last seven years. She also has a written business plan in place for future growth. Her DTI is 20% and she has spent the last year getting rid of older debts to improve her credit score.
Borrower B has been self-employed for one year. He has not obtained a business license yet and only has five clients. During the past year, his income has not been steady and there were some months when he didn’t make much at all. His DTI is 45%, and he does not have any cash to put toward a down payment.
It’s easy to see how Borrower A would be the better option for a mortgage. But even if you are more like Borrower B, you can still get approved. It will take some time, but with the right help, you can become a homeowner too.
At Community First Credit Union, we’re here to help. If you’re self-employed, talk with us about your options for homeownership or call us at 904.371.8150. Together, we can assist you in reaching that goal.