Being an entrepreneur and running a business definitely has its benefits and drawbacks. One such con, as compared to someone who gets a wage, qualifying for a mortgage to purchase real estate can be a bit tougher. Prior to 2008, many self-employed people could easily just state their income and assets—known as a SISA loan. However, post-2008, this is no longer possible.
When applying for a real estate mortgage as a W-2 employee, the process is pretty straight forward. They look at 2 years worth of tax returns, paycheck stubs, and bank statements. It’s a simple plug and plays a formula used to calculate debt to income ratio. But if you are self-employed, the process is quite a bit more involved in certain aspects.
How the process works…
The process is pretty similar to that of a W-2 employee when applying for a commercial real estate loan, but you will be under more scrutiny. You will first, of course, locate the perfect property. Then you’ll look to get a rate quote, fill out an application, provide the necessary documentation, and finally, sign all of the paperwork. The REALTOR and loan officer should help you through the process. They will definitely assist you in the initial phase as you seek to get pre-qualified. The bank will look at down payment, credit score and debt to income ratio. So the question stands, why is it more difficult for a small business owner?
This all has to do with proof of income. Someone with a salary or wage can simply show pay stubs. Self-employed borrowers, on the other hand, will need to show their entire 1040 tax returns–including all schedules. As an entrepreneur, you’re likely familiar with your ability to write off numerous expenses. Which in turn makes it so that your final net income is a lot lower. When trying to qualify for a real estate based mortgage, this can actually make it more difficult. Most lenders want to see your debt to income ratio between 31-43%.
The mortgage underwriter will carefully look at your business, in terms of is it thriving or does it seem to be declining. They will most likely utilize Form 1088 in their efforts to compare your business year over year.
Additionally, they will review K-1 income to qualify borrowers using only cash distributions for the past two years.
However, Good News…
Fannie Mae recently came out with some new guidelines to help the 14 million self-employed borrowers across the country. One of the main highlights: there is a documentation requirement reduction. In some cases now they only need to see one year of tax returns versus two. There is also a new income calculation for borrowers who may not have much income history. The biggest change comes in terms of reviewing business cash flow. Banks generally scrutinize how much is coming in versus what’s going out. This lets them know if you can in fact make your real estate mortgage payments.
In the past, qualifying for a mortgage as a self-employed borrower entailed you only using the amount of money equal to the distributions received from the business. So the problem became, if the owner did not take cash distributions then this was seen as a red flag—as they figured the business wasn’t making enough to pay the owner. Therefore the borrower would then have to prove that there was in fact sustainable cash flow that they could tap into when needed.
Now, however, as lenders don’t require as much paperwork, they also don’t require the borrower to show quick access to cash.
Some Further Tips On Getting a Real Estate Mortgage
If you are considering buying a home, spend some time really thinking the decision through as it is a big one, especially if you are a small business owner. Purchasing real estate is a major commitment. Take all measures to ensure that your real estate transaction does result in a smooth process. Understand going in, as a business owner, how lenders will look at your income. You may want to consider reducing the number of deductions you do take on your taxes. Also pay attention to your credit score. Many self employed loan applicants tend to have lower scores than wage earners. Credit scores are heavily weighed when you decide to purchase real estate. If your score is less than ideal, look at steps you can take to improve it. Even a few points can make a huge difference in terms of your loan application being accepted or denied.