When you apply for a mortgage, your lender will determine your ability to repay the loan by verifying your income. For employed individuals, it’s almost straightforward since you can use recent tax returns, pay stubs, and W-2s. But what happens if you’re self-employed?
Whether you’re a small business owner, gig worker, freelancer, or independent contractor, you’re probably wondering how you can calculate your income for a mortgage. In this post, you’ll learn how to calculate self-employment income to know whether you will purchase or refinance a property.
Traditional and NQ Mortgage Loans
Who is Considered Self-Employed Individuals?
A self-employed person is anyone who works for themselves rather than for a company and typically reports self-employment income. However, you must prove that you’ve been self-employed for at least two years.
25% or More Ownership in a Business
You’re considered self-employed if you own 25% or more of a business. However, mortgage lenders will require you to provide additional documentation for the business to evaluate qualifying income.
As a sole proprietor, you’ll report your business income on Schedule C of your tax returns. And if you operate under a partnership, corporation, or S corporation, you’ll file your business tax returns and report the company on Schedule E of your personal tax returns.
A freelancer is a self-employed person who earns money by providing services to multiple clients, typically for a short term. While freelancers can take on contract work from companies and organizations, they are still considered self-employed.
A contract worker also referred to as an independent contractor or 1099 earner, is one who enters into a contractual agreement with a company or business to provide specific services for a given period of time in exchange for a fee. Though they sign a contract, they remain self-employed individuals.
As the name suggests, seasonal workers provide their services to meet a company’s temporary needs at certain times of the year. This includes businesses that operate in peak seasons and remain closed during slow seasons.
Gig and Side Job Workers
Gig workers are independent contractors and freelancers who work on short-term projects for various clients. They normally enter into formal agreements with in-demand companies to offer services for pay.
Self-employed Gross vs. Net Income
For self-employed individuals, gross income is your income from all sources before taxes and other deductions. This can include your wage from your employer, rental income, dividends, and compensation from services before retirement contributions and health insurance premiums are deducted.
On the other hand, net income or take-home pay is the amount of money you receive after taxes and deductions have been taken out from your gross income. Most W-2 employees receive their net income in a paycheck with taxes already deducted, while self-employed people receive gross pay, which they are responsible for paying their own taxes.
Traditional and NQ Mortgage Loans
What Type of Income Will Mortgage Lenders Consider?
When applying for a mortgage, lenders will need proof of steady income to ensure you can manage your monthly payments without defaulting. Depending on your situation, lenders generally look at different sources of income, including:
- Self-employment Income: This is arguably the most popular type of income that lenders look at when evaluating your eligibility for a loan. You’ll need to provide alternative documentation, such as bank statements, profit and loss financial statements, or liquid assets, as proof of income instead of using pay stubs, tax returns, and W-2s.
- Investment Income: If your investments earn you interest and dividends, lenders will want to see that too. You must provide documentation showing you have received interest payments and dividends from your investments over a specific period, typically two years. Lenders will use the information to determine if you qualify for a mortgage loan.
- Rental or Property Income: For real estate investors with rental property, lenders will want to see your rental income. You must show proof of rental income in your tax returns.
- Spousal or Survivor’s Benefits: Mortgage lenders also consider spousal or survivor’s benefits as sources of income that can help you qualify for a home loan. If you want to use this type of income to secure a mortgage, you must prove that you’ll receive these benefits for the next three years.
- Retirement Income: If you’re using your retirement accounts to apply for a mortgage loan, your lender will need to prove that your payments will continue for at least three years from the date of your mortgage. Most lenders use 70% of these accounts to evaluate your eligibility since they can drop in value.
How to Calculate Self-Employed Income
Most mortgage lenders want to see the stability of your income and at least two years of self-employment income.
To calculate your self-employment income for a mortgage application, follow these simple steps:
- Find your net income from Schedule C on your tax returns for the two most recent years
- Add the two figures together
- Divide the result by 24
For example, if your net income for year one was $95,000 and year two $98,000, the income for a qualifying mortgage will be $95,000 + $98,000 = 193,000 divided by 24. The result is $8,041per month.
It’s important to note that if your income declines year after year, lenders may be hesitant to loan you because it could indicate a falling business.
What Else Can Self-Employed Individuals Show as Proof of Income?
Other ways you can prove your income as a self-employed borrower is by providing:
- Bank Statements: Your bank statements can serve as proof of income when applying for a mortgage. Lenders usually require 12 to 24 months’ worth of bank statements. If you use one account for personal and business banking, you’ll need to highlight all the business-related payments.
- Profit and Loss Statements: A profit and loss statement shows all your total revenue, business expenses, and profits over a given period of time. You’ll not only use it as proof of income to qualify for a loan program but also to help make better business decisions.
- 1099 Forms: This is a tax form given to freelancers and independent contractors. The 1099 form contains the self-employed individuals’ tax identification number or SSN and the amount paid to you by the client, which is why it can serve as proof of income.
- Self-Employed Pay Stubs: You can also create pay stubs if you’re self-employed using a stub generator and use them as proof of income. For a self-employed pay stub to be considered legally valid, it must include gross pay, deductions like Medicare, Social Security, state and local taxes, and net pay.
Are There Mortgage Loans Specifically for Self-Employed Individuals?
Yes, there is a wide range of mortgage products for self-employed borrowers. The most popular loan options include:
- Bank Statement Loan: You can get a mortgage using your bank statement rather than tax returns, pay stubs, or W-2s.
- Asset Qualifier Home Loan: If you have a lot of assets, you can use them to secure a mortgage loan.
- Investor Cash Flow Home Loan: This is ideal for real estate investors as they can use the cash flow from their property to qualify for a mortgage,
- Jumbo Loan: A loan product for homeowners looking to purchase property exceeding the conforming limits set by the Federal Housing Agency.
- ITIN Mortgage: Individuals without Social Security numbers can use ITIN to qualify for a home loan.
- 1099 Income Loan: Freelancers and independent contractors can use 1099 forms to pursue their dream of homeownership.
- Foreign National Program: Non-citizens can purchase a house or refinance in the U.S. with a foreign national program.