How to Play the Mortgage Game if You’re Self-Employed
A look at the extra hurdles facing self-employed borrowers
By SUSAN JOHNSTON
January 15, 2013
Mortgage lenders have tightened requirements across the board in the wake of the housing crisis, but now—even as the workforce increasingly moves away from traditional 9-to-5 employment—self-employed borrowers have a tougher time securing a mortgage. It's an issue felt by many, as the Small Business Administration reported that the number of Americans who were self-employed approached 9.9 million in the second quarter of 2012.
Sally Herigstad, a freelance writer in Enumclaw, Wash., encountered problems last year when applying for a mortgage. Before offering to place a 26-percent down payment on a house, Herigstad says she and her husband had heard that getting a mortgage would be harder than it once was, but they had no clue just how difficult the process would be.
"Some of the hurdles were uneven self-employment income, a [one-time] start-up expense [from] two years earlier that the lender categorized as ongoing, and the requirement that we qualify for payments on both our old house and our new house, despite the fact that we planned to rent out the old house," she says.
When their first loan officer couldn't get them financing, Herigstad took her real estate agent's referral for a new one who would be able to "move heaven and earth to get me this loan." After many sleepless nights and nearly losing the house to a short sale due to delays, the couple finally closed in October.
It may come as small consolation to Herigstad, but she's not alone in facing mortgage obstacles. "Everybody has a higher burden of documentation," says Joe Parsons, managing partner of PFS Funding, a small mortgage banker in Dublin, Calif. "For self-employed borrowers, what used to be the godsend was stated income loans."
In a stated income loan prior to the housing crisis, the lender did not verify the borrower's income using tax returns or W-2s. Nowadays, though, most mortgage lenders want to see at least two years of a self-employed borrower's Schedule C, the tax form that reports income or loss from a business. If income increases between year one and year two, the lender averages the two. If the second year's income is lower, the lender will use that number. People who individually operate multiple companies will usually need to provide two years of tax returns for each company in which they own 25 percent or more—potentially creating paperwork headaches.
Documenting the source of funds for a down payment can add additional stress. "Any deposits more than about $400 or 500, if they are not clearly identified as to their source, they will need a paper trail," says Parsons. "Many self-employed borrowers who use their business and personal accounts interchangeably or they have cash from a brick-and-mortar business [encounter problems because] they cannot document acceptably."
The real kicker: Mortgage eligibility is based on net income, meaning all those business deductions actually count against the borrower. "Self-employed borrowers try to write off as many expenses as they can, but that tactic may hurt them when securing a loan," says Patrick Ruffner, vice president of mortgage lending at Guaranteed Rate, an independent mortgage company based in Chicago.
One exception is depreciation on business-related purchases, which can be added back into the borrower's net income to help them qualify. "Let's say you have a car that you have purchased for your business. You can write off some depreciation. It's a paper loss, not a cash loss, so whatever you're claiming for depreciation can be added into your net income," Ruffner says.
With tax day approaching, self-employed professionals planning to apply for a mortgage in the next few years should discuss the issue with their accountant now. "If buying or refinancing a home is in your three-year plan, don't write off every business expense you can write off," Ruffner advises. "As a last resort, amend your tax return to show that you have an increased net income." (The IRS has a three-year statute of limitations on amended returns.)