Before the Great Recession, lenders and banks were more lenient in their lending standards than they are today. But the financial crisis of 2007-2008 changed everything. During and immediately after the crisis, millions of borrowers, including self-employed individuals, who could no longer afford their monthly mortgage payments lost their homes to foreclosure.
Considering all these, anyone can easily understand why getting pre-qualified for a mortgage nowadays is harder than it once was. Since lenders have adopted stricter lending criteria to protect themselves against the risk of defaulting, below are a few things a small business owner needs to do in order to overcome obstacles and win the mortgage “game.”
Provide Proof of Self-Employment and Income
The first thing a small business owner needs to demonstrate is that he or she has been in business for at least two years. According to the requirements of each lender, a small business owner usually needs to provide professional and/or business licenses.
To assess the monthly income of self-employed applicants, lenders require different documents based on the business structure. Thus, a person flirting with the idea of starting a business and getting a mortgage in the near future should keep in mind that the business structure can greatly affect his or her chances of getting pre-qualified for a mortgage.
If an individual is part of a business with multiple owners, for example, he or she must obtain permission from the other partners before accessing and handing over any documents to a lender.
Depending on the structure of a business, the lenders will want to see:
- Two years of personal tax returns (a complete list of 1099 Forms, copies of the Form 1040, W-2 Forms if the person pays him or her self a salary, and/or schedule C, D, E, F);
- Two years of business tax returns (K-1 Forms, 1120 Forms for Corporations, and/or 1120S Forms for Partnerships and S Corporations);
- bank statements, balance sheets, profit and loss statements;
- CPA letters indicating the applicant as the owner of the business, if applicable;
- Explanation letters if the applicant receives income only several times a year.
Regardless of the documents required by a lending institution, having all the paperwork put together by a bookkeeper will give underwriters the confidence that the documentation is accurate.
On a side note, the real kicker is that lenders consider the income after the business expenses have been deducted. This can seriously reduce the loan amount a small business owner can qualify for, and even result in rejection. Let’s say that a self-employed professional pulled in $70,000 last year in revenue and wrote off $45,000 as business expenses. The lender will only consider $25,000 ($70,000 – $45,000), or $2,083 per month, as real income.
For certain loan products, small business owners are permitted to include documentation for only one year of personal and business tax returns. Also, part-time self-employed professionals no longer need to show proof of income if they get pre-qualified for a mortgage based on the W-2 Form.
Explain Income Fluctuations
Mortgage eligibility depends as well on the financial stability of the applicant. Even if the income looks good, being able to clearly explain income fluctuations and dips can improve an applicant’s chances of getting pre-qualified for a mortgage.
Let’s assume that a small business owner earns $100,000 in the first year and just $50,000 in the second year. Even though the overall income is $6,250 per month, the lender might still reject the application. Why? Declining revenues could indicate the existence of one or more factors that may lead to business failure.
Make a Hefty Deposit
A self-employed home buyer able to make a larger deposit than the one required by the lender will be more likely to get pre-qualified for a mortgage. Not to mention that a larger down payment on a house will result in a smaller loan amount and monthly payment. A stable financial history, a good credit score, and low DTI and LTV ratios are a few more factors that increase (or decrease) the chances of mortgage loan approval.
Before applying for a mortgage, a small business owner should plan everything down to the smallest detail. For instance, he or she should also think about other options if the yearly income isn’t enough to get pre-qualified for a mortgage. In this particular situation, the applicant could ask a family member with a solid income to co-sign the loan.
To see if you qualify for one of our mortgage programs or to find out other details about getting a home loan, please call one of our mortgage professionals today. Dedicated to helping home buyers and homeowners achieve their goals of homeownership, North Florida Mortgage can help you secure a loan product that is the right fit for your financing needs.