It may be harder than you think to get a self-employed mortgage if you aren’t careful about how you do your tax write-offs.
Self-employment offers a measure of freedom. You can set your own hours, work at your own pace, and control your income. But if you’re thinking about buying a house, self-employment might be the thing that stands in your way of ownership.
I learned this the hard way eight years ago when applying for our first mortgage. And after a recent discussion with another self-employed person, I realized that some self-employed people don’t fully understand the potential challenges when trying to purchase a home.
The fact that people can work for themselves and generate enough income to consider buying a home is commendable. Being your own boss takes self-motivation, determination and a lot of hard work. For that reason, I personally applaud everyone who can turn an idea into a money-making venture. Unfortunately, mortgage lenders don’t make it easy for our kind.
Start planning two years in advance before applying for a mortgage
If you’re in the market for a self-employed mortgage (that is, you’re self-employed and buying a house) your lender will require at least two years of tax returns — which I completely understand. This shows that your business is a consistent source of income, and not a fly-by-night operation. To be fair, mortgage lenders are risking large sums of money, so they have to be cautious. I don’t take issue with this. What I do take issue with is how lenders treat self-employed income. Let me explain.
Buying a home has become harder for everyone, but it’s particularly challenging for the self-employed. And if you’re new to the freelancer/independent contractor/self-employment game, you may apply for a mortgage not realizing that lenders base affordability on income after tax write-offs.
It’s a catch-22.
Be careful with tax write-offs if you want to apply for a self-employed mortgage
On one hand, we need tax write-offs (business supplies, health insurance, charitable donations, depreciated value of assets, mileage, etc.) to reduce how much we owe the federal and state government. But for every write-off claimed on your tax return, the less you’ll qualify for when applying for a home loan. This is because lenders look at your adjustable gross income, which is total income minus deductions.
Let’s say your freelancing business brings in $80,000 a year. That’s a nice piece of change, and you’re probably thinking that you’ll qualify for a decent home. However, in an effort to reduce your tax liability, your accountant might look for any eligible deduction. You may welcome the chance to take $20,000 worth of tax deductions which would bring your adjustable gross income down to $60,000.
I understand that lenders have guidelines and nothing we can say or do will change the lending process. However, I think the guidelines are unfair to self-employed people when we start looking for a self-employed mortgage.
If an employee applies for a mortgage, lenders will use his gross income when deciding how much he can receive — and as we all know, nobody takes home their gross income. An employee might earn $50,000 a year, but after taxes, health insurance and 401(k) contributions, he takes home far less. Yet, mortgage lenders don’t care about take-home pay. It doesn’t matter if an employee brings home $35,000 a year after payroll deductions, the bank pre-approves a mortgage based on his $50,000 salary.
This is what upsets me.
It shouldn’t be harder to get a self-employed mortgage, but it is
If self-employed people can’t qualify for mortgages based on what they actually earn, then employees shouldn’t be able to qualify for mortgages based on their gross income. I’m sure some mortgage brokers will argue that self-employed income is fickle. But in today’s unpredictable job market, self-employed income might be more reliable than a job. Besides, the self-employed people I know are hustlers. They might lose clients or accounts from time to time, but they have the drive and motivation to replace lost income.
It is what it is, and I highly doubt banks will change the way they view self-employed income. So, if you’re a freelancer and thinking about buying a house soon, I suggest minimizing your number of tax write-offs for the next two or three years. I know, this sucks and you’ll owe more in income taxes. But until banks relax their standards and stop penalizing us, it’s what we have to do.