How Lenders Evaluate Self-Employed Borrowers
As more and more people choose flexible work arrangements, we have received an uptick in requests for information about how contractors can qualify for a mortgage.
Prior to the financial crisis, lenders put less emphasis on documented income, relying instead on a prospective borrower’s down payment (equity) and credit history. While this approach was fine when property values increased 10%+ per year, its flaws were exposed when property values dropped significantly in the late 2000s. Today, there is an increased focus on a borrower’s “ability to repay” as evidenced by a documented income history and a likelihood for that income to continue.
However, many borrowers who are self-employed or are choosing less traditional employment opportunities are finding qualification more difficult, despite having large down payments and exceptional credit.
Lenders that underwrite to Agency (Fannie & Freddie) guidelines will look for a two-year history of your contract income. They will verify this income by requesting copies of your 1099s and your two most recent tax returns to confirm that the income was both earned and reported.
A challenge for self-employed borrowers is that most lenders (including those in our marketplace) only consider taxable income as "qualifying.” Because many self-employed people take common deductions, they end up reporting significantly lower taxable income than their "gross" income. This can create issues for the borrower to qualify based on their “debt-to-income” ratio, a percentage calculated by dividing monthly debts, including the expected mortgage payment, and that “qualifying” income. This results in some self-employed borrowers being approved for lower loan amounts than expected, or being denied approval altogether.
It is possible to qualify with one full year of self-employment if you can show documentation of a two-year history of salaried W-2 work that is of a similar nature, and your self-employed work earns you an equal or greater income compared to that prior salaried position.
Lastly, there are some lenders, typically banks, who specialize in lending to consumers with non-traditional employment. Oftentimes these lenders will charge higher rates to compensate them for the additional perceived risk, limit the product types available, and/or require additional forms of collateral, such as putting money on deposit at the institution that can be used to pay back some of the loan in the case of missed payments.