Being self-employed definitely has its perks – setting your own hours, choosing your projects – but it can be a headache when you're applying for a home loan. Lenders much prefer applicants who have worked at one salaried job for at least two years, even if your annual income is just as high. It's frustrating, but lenders have to make sure that you'll be able to pay them back.
Can you get a mortgage as a contractor? Yes. But you have to jump through a few more hoops to get there.
1. Find Out: Are You a Contractor?
In most cases, you qualify as an independent contractor if you're not on anybody's payroll and don't receive a W-2 at the end of the year. You usually pay for all of your own equipment and are hired for the duration of a project, not in any kind of permanent capacity. Fortunately, as an independent contractor, you usually get to set your own hours.
Being an independent contractor has its ups and downs, but lenders usually focus on the downs. There's no guarantee that you'll be employed next year. You don't have paystubs to show how much you take home every month.
It's not a lost cause; you just have to prove your case in other ways.
2. Find Out What They Want
Getting a home loan as a contractor is all about making your case. You have to show a lender that you're a responsible borrower, have the income to afford monthly payments, and have a plan “B” in place in case something goes wrong. Here's what they look at to figure that out.
Mortgage lenders generally like to see a credit score of at least 620, but that's the minimum. As a self-employed borrower, your perceived risk is higher, so lenders will want to see a score of at least 700.
Employees have an easier time proving monthly income, purely because they receive a regular paycheck. For a contractor home loan, they take the past two years of the contractor's adjusted gross income and divide it by 24.
(For reference, your adjusted gross income is your total income after qualifying payments and deductions. Some people call it taxable income.)
If you recently became self-employed but went into business from the same field, you might be able to present one year's income tax forms and W-2 forms from your previous employer, but lenders strongly prefer a longer business history. They really want to see consistent income, preferably with an upward trajectory.
Even if you have a good history of self-employment income, lenders want to know that you have enough money to keep paying if your business goes through a dry spell.
First, you'll want to offer at least 20 percent of the home's purchase price as your down payment. Not only will this give your lender more confidence, but it will also relieve you of having to buy mortgage insurance.
You'll also want to have plenty in cash reserves. These are liquid assets that will still be available to you after you close on the home.
Borrowers who earn regular salaries have to have cash reserves as well, but the self-employed need to have more. Ideally, you'll have six months' worth of mortgage payments in savings accounts, CDs, or other completely liquid accounts. (Retirement accounts don't count.)
3. Collect Your Documents
You may have plenty of money in the bank and strong profit margins in your business, but you'll have to prove it if you want to get a mortgage. Don't leave for the bank without all of the following:
- Personal and business income tax returns for the past two years
- Profit and loss statements, reviewed and audited by a CPA, for the current year to date
- A CPA statement or business license proving at least two years of business
- Business and personal bank statements
- A complete list of your assets and debts
- Documentation for any recent large deposits to your accounts
Your lender may also require other documents, so make sure you have access to all of your accounts and passwords just in case.
Submit and Then ... Get Rejected?
You don't want to think about rejection, but it happens to hundreds of thousands of borrowers – 627,000 in 2015, according to the Federal Reserve. Here are three of the most common reasons:
1. Your debt-to-income ratio (DTI) is too high. Your DTI is usually calculated by dividing your regular monthly payments by your monthly gross income. Lenders usually want a DTI of no more than 43 percent.
2. Your credit history isn't good enough. Maybe you missed some payments when you were first starting up your business, or maybe you recently took out a loan to invest in new equipment. Whatever your circumstances, you're in company with 26 percent of rejected applicants.
3. You have too many tax deductions. This one is a particular sticking point for independent contractors, who may write off business expenses to save on taxes. Unfortunately, this can decrease your taxable income to below an acceptable level.
What Can You Do?
Whatever the reason, rejection isn't the end of the road. First of all, if you know why the lender rejected your application, you can work on fixing the problem. If your credit score was too low, for example, you can work on bringing it back up by spending a year paying off your debts.
Try Other Loan Options
You can also shop around for an alternative loan program or try a different lender. See if you qualify for a loan from the Federal Housing Administration (FHA), which accepts lower credit scores, or a Department of Veterans' Affairs (VA) loan, which doesn't require a down payment. There may be a loan out there that suits your circumstances.
Tap into Your Home Equity
If you already own a home and are looking to relocate or buy a second home, you might be able to use your equity to get a mortgage application approved.
One option is to take out a home equity loan, which can give you the money you need to pay off the debt that is hurting your credit score or make a larger down payment. But then you have the additional problem of new credit, which can hurt your credit score.
There is an alternative option. EasyKnock has developed a unique program known as Sell and Stay, which allows you to sell your home to us and remain in place as a tenant. You keep paying rent until you're ready to move or buy back the property.
Your Win-Win Situation
Sell and Stay isn't a loan, so it doesn't appear on your credit report. Nor does it require you to uproot your household while you get ready to buy your dream home. It's just your equity, without strings or a lengthy approval process. The application process is easy – contact EasyKnock today to learn how.