The Self-Employed Homebuyer

Generally speaking, it's tougher for the self-employed buyer to qualify a mortgage. Because cash flow and profitability for the self-employed buyer are often tough to predict, loan-guaranteeing income can be difficult to prove to the mortgage lender. In addition, the low- and no documentation loans of the 1980s, many of which were made to self-employed borrowers, have shown significantly higher rates of default than standard documentation loans, making lenders even more wary. Two major areas in which self-employed borrowers are challenged by the mortgage loan process are net income and documentation.

While income tax deductions are a major advantage of self-employment in the month of April, they can be a negative factor in qualifying for a mortgage loan. This is due to the fact that deductions lower the business owner's net income. For example, a self-employed individual currently making a $1,200 mortgage payment may find it impossible to qualify for a payment of even half that amount on a new loan, even after the lender adds back some of the deductions for the purpose of evaluating the application.

The self-employed borrower must also provide extensive documentation to the lender. This is mandated by the secondary market because there's greater room for the embellishment of information and verifications by self-employed individuals. Additional documents that the lender may require the self-employed applicant to furnish (apart from the standard items that must be provided) may include, for example, copies of two years of filed income tax returns with all necessary schedules, an audited or professionally-prepared balance sheet for the previous two years, and a year-to-date profit and loss statement for sole proprietors. If the business is a corporation or partnership, signed copies of the previous two years' federal business income tax returns (with all schedules), a year-to-date profit and loss statement, and a business credit report may be necessary.

Lenders generally calculate the income of self-employed applicants by using the following formula: with the provided income tax returns, the applicant's net income (after expenses but before taxes) for the past two years is computed. Then the year-to-date income (again, after expenses but before taxes) for the current year is added to the total. Finally, this sum is divided by the total number of months involved to arrive at the borrower's average monthly income.

Self-employed buyers who -- for whatever reason -- experience an inordinate amount of difficulty in qualifying for a loan may consider some form of creative financing to obtain a mortgage. Seller financing is always an option, even though the seller may require the same credit report or other income verification documents that a traditional lender does. Another possibility could be to liquidate or take loans against other personal assets, such as certificates of deposit (CDs), stock, or life insurance policies. A third option might be to apply for a business loan rather than a personal mortgage. If the borrower has a good business relationship with a lender, he or she could possibly use a commercial loan to fund the home purchase.

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