Mortgages and the Self-Employed Borrower
Greta Jordan Williams | 3/17/2017, 1:30 p.m.
In my last article, I discussed the first step to home ownership which was understanding your credit. The next step to homeownership is understanding your full financial picture. Most borrowers will be W-2 employees, meaning they’re employed full-time, receiving monthly or bi-weekly payments from a company. The company will in-turn issue pay stubs that show all tax deductions, insurance deductions, 401K payments, etc. At the end of the year, the company will issue a W-2 to use for your federal tax filing.
Borrowers with a W-2 will simply give all of this information to a lender for approval. This scenario is pretty simple, but what happens if you’re not W-2 employee? What do you do if you own your own business or receive 1099s? For these borrowers the steps can be a bit more challenging.
Wikipedia defines The American Dream as the set of ideals (democracy, rights, liberty, opportunity, and equality) in which freedom includes the opportunity for prosperity and success, and an upward social mobility for the family and children, achieved through hard work in a society with few barriers. There are many avenues that can lead to achieving “the dream” with the most popular being business ownership. Being your own boss has its advantages such as setting your own hours, dress code, policies and procedures, etc. Another advantage is being able to “write off” business expenses on your tax returns. Not owing “Uncle Sam” at the end of the year is definitely a blessing, but can quickly turn into a curse when applying for a mortgage.
When applying for a mortgage, the lender examines your complete financial picture. They’ll ask you to submit two of your most recent pay stubs, two month’s bank statements and tax returns for the past two years. Self-employed borrowers normally do not receive pay stubs, however, there are exceptions. If your company is a registered LLC and you’ve structured your business so that you are paid from the LLC, you will very likely have pay stubs but for the sake of this article, we’ll use a sole proprietorship as an example.
After taking all legal and available tax deductions, a self-employed borrower’s income can be much less than expected, therefore reducing the loan amount that the borrower will qualify for. It can also result in loan denial.
If you are self-employed and want to purchase a home, it is imperative that you take the time to plan. You should ensure that all tax returns have been filed on time. Your last two years tax returns should show an increase in income. The lender determines your monthly income by taking an average of the two years after write offs. Declining income will reduce your tax liability, but lenders will interpret that decline as an unstable or inconsistent business, therefore resulting in possible loan denial. You must also report all income to the IRS, including cash. If they don’t know about it, you can’t use it. Pay business debt with a business account or business credit card. Do not comingle personal funds and business funds. Once those waters have been muddied, there is no separation.