Mortgage Refinancing for the Self-Employed
(Updated November 2014)
America is a country that applauds its entrepreneurs, although you won't hear much cheering coming from mortgage bankers. That's because the self-employed-who often have complicated tax forms and show less income than their corporate counterparts-may have trouble qualifying for a conventional loan or mortgage refinance. But even a crabby banker would have to agree that there are significant reasons why the self-employed should consider becoming homeowners or tap into their home equity.
For someone who works as an employee of a business or other institution, documenting income for a mortgage application is easy - you simply provide your recent pay stubs and your W-2 tax statements for the past two years. But for someone who doesn't get a paycheck or W-2, who generates their own income and pays themselves, it's a different story.
Contact your lender and find out what documents they'll need before applying for a home loan. These usually include two years of tax returns, a current profit and loss statement, and bank and investment account statements. If you're refinancing, they'll also need your pay-off balance, and information about your current mortgage.
If you've been self-employed for some time and your earnings have been relatively steady, you should be in good shape. You'll generally be asked to document your earnings by providing your last two years of tax returns. You may also be asked to provide tax returns for your business, as well as profit-and-loss statements and a balance sheet.
Your income may also be a factor, particularly if you're looking to refinance to a shorter loan term with higher payments, such as going from a 30-year to a 15-year fixed-rate loan. A mortgage income calculator can help you take into account your earnings, debt payments and other liabilities, and the cost of the new loan to figure it all out.
The other key factors affecting your ability to refinance will be your credit score and the amount of equity you have in your home. If you have less than 20 percent equity, you may need to try to refinance through the federal Home Affordable Refinance Program (HARP), but you can still do that as a self-employed person as long as you can document your income.
The documentation trap
If your earnings are irregular, that can present a challenge in qualifying for a mortgage. What lenders will typically do is take your total income over the past two years, then divide it by 24 to produce your monthly income for that period. However, if there's a dramatic difference in your earnings between the two years, they may skew their calculations more toward the lower-earning year to be more confident you'll be able to make the payments.
Another problem is that self-employed persons tend to take a lot of tax deductions for business expenses. While this can save you a lot of money, it also reduces the adjusted gross income you report on your tax form - and that's the figure your lender will be looking at. It doesn't matter if your effective earnings are higher than that and you could easily afford a higher monthly mortgage payment - your lender is going to base your debt-to-income ratio on that figure, the same as they would for a W-2 employee.
No-doc or stated income loans
It's often difficult for the self-employed to qualify for a mortgage loan due to complicated document needs and tax returns. In the past, a non-salaried worker could opt for a "low-doc" or "no-doc" loan. In fact, during the early 2000s, almost anyone could get what's called a "stated income" loan, where no proof of income was required.
But with the dramatic tightening of mortgage credit that's happened since the housing market crash, low doc/no doc loans practically disappeared as lenders demanded strong evidence of a borrower's ability to repay before approving a mortgage.
Stated income loans have made something of a comeback recently, as lenders have recognized that the self-employed people who seek them often have very solid finances and are excellent credit risks. Some lenders now will even approve mortgages without even tax returns, but rather bank or brokerage statements proving you have enough assets to cover six to 12 month of payments. However, the equity requirements are stricter - you'll need at least 30 percent equity in your home to refinance this way - and the mortgage rates are significantly higher than you'd pay for a loan qualified for in the conventional way. You'll also need an excellent credit score - likely 740 or above.
New federal rules enter the picture
A more recent barrier to obtaining a stated income loan are new federal regulations under the lending reforms required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under Dodd-Frank, new standards for what are called "qualifying mortgages"(QM) have been developed and are supposed to reflect mortgages where the lender has thoroughly verified the borrower's ability to repay the loan.
Lenders don't have to meet the QM standard on all mortgages they write, but those that do not can't be sold to Fannie Mae, Freddie Mac or the FHA. In addition, lenders who write a non-QM loan could leave themselves open to getting sued for predatory lending practices if the borrower later can't keep up with their loan payments. That makes non-QM mortgages more expensive. And stated income loans don't meet QM standards.
One of the main gripes of the self-employed is that they must pay twice as much Social Security and Medicare taxes as an employee of a company. That's why the tax deductions that mortgages provide should be highly valued. The interest portion of your mortgage payment is tax-deductible, as are your property taxes. These two write-offs can help ease any heavy tax burden.
Embarking on a mortgage refinance is never an easy task, and it's particularly onerous for the self-employed. But as is usually the case for the ambitious entrepreneur, many of these obstacles are worth hurdling.
Fixed rates, shorter terms
Many people who are self-employed choose a fixed-rate mortgage instead of an adjustable-rate loan. It allows for easier planning, and there's no scrambling if your mortgage rate adjusts higher. You can also choose a shorter term, which allows you to pay off the mortgage earlier. This can result in more cash to invest in your business.
On the other hand, an adjustable-rate mortgage (ARM) is often preferred by those with irregular earnings, particularly if they're planning to pay down their loan in large chunks as money is available. An ARM can help minimize your monthly loan payment by getting you a lower rate than you could on a fixed-rate loan, although you do have to be prepared for a possible payment shock if interest rates rise considerably by the time the rate on the loan resets.