Traditional mortgages rely on W-2s and verifiable income, which the bank underwriters use to determine the loan interest rate, monthly payment, and risk of default. For those with W-2s and monthly pay stubs, income is fairly easy to determine. For self employed home mortgages, income cannot be verified using official W-2 documents or employer paystubs. The lender must use different estimates to determine the monthly and annual income of self employed people, and can’t be as certain of future income as they can for wage earning borrowers.
Lenders will first look at the personal and business tax returns for the self employed loan applicant. Most self employed home mortgages require the borrower to have been in business for two complete calendar years. These years’ tax returns are additional together with the year to date profit and loss statement of the borrower, and the total is divided by the number of months involved. The end figure gives the bank the monthly income of the borrower.
For many self employed people, it’s in their best interest to take high deductions and business write offs on their tax returns, consequently lowering the net income on which they pay taxes. While this practice is advantageous at tax time, to a lender it gives the impression that the borrower had low income and high business expenses. Because it is difficult to determine accurate income from tax returns, borrowers may then be asked to supply audited financial records and income statements certified by an accountant. Some self employed home mortgages also require profit and loss statements, bank statements, and other financial records to get a clear picture of income.
Once monthly income is determined, the lender looks at the debt of the borrower. In the case of self employed home mortgages, calculating debt can be as complicated as calculating income. The lender will add up all the debt, including the mortgage payment, and compare it to the monthly income. The ratio of debt to income generally shouldn’t be more than 36%. However, many self employed people use their business to pay some expenses, such as car payments and credit cards. The borrower can provide proof that the business pays some of the debt, and have it removed from the debt income ratio calculation. Flexibility and good records from the applicant can help the lender make these adjustments to create an accurate picture of debt and income for the self employed.