How Mortgage Lenders Calculate Self-Employment Income

March 13, 2017

There’s no doubt about it, the burden of income documentation for the self-employed is more complicated than what it is for salaried employees. But the reason for the higher level of documentation is that the process for lenders to calculate self-employment income is more involved. By knowing how mortgage lenders calculate self-employment income, you’ll be in a better position to provide the necessary documentation, as well as having a better understanding of why it’s needed.

How Long Must You Be Self-Employed?

The general rule is that mortgage lenders look for you to be self-employed for at least 24 months. They will look to document this history through a variety of sources, including two years income tax returns, a verbal or written verification of employment (VOE) from your CPA, or a copy of a business license.

The reason for the two-year requirement is that lenders understand that income from self-employment is usually less predictable than what it is for salaried borrowers. As such, they will want evidence that you have been in business for at least two years. They will then average your income over that two year period.

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However, they may also accept a shorter time frame. They may consider income if you have been self-employed for between 12 and 24 months, but never less than 12 months.

If they do accept 12 – 24 months, you will have to provide your most recent income tax return, clearly demonstrating that you have received self-employment income for the entire 12 months covered by the return.

If they do accept less than 24 months, they will also verify your previous earnings history, to cover two years of employment. The lender will want to know that you have at least been employed in a similar line of work, even though it’s from a job, and that you have the skills, qualifications and earnings history to support the self-employment income used to qualify.

Documentation Requirements for the Self-Employed

If you’re self-employed, you should understand that the documentation requirements for your income will be more extensive than what they would be if you were a salaried employee.

As noted earlier, the lender will look to verify your self-employment by contacting your accountant or by requiring a copy of your business license, if applicable.

Expect to provide at least your most recent income tax return, and very possibly your returns for the past two years. This may also include business tax returns if your business is a partnership, a corporation, and “S” corporation or an LLC.

Any tax returns required must be signed and complete with all schedules included.

Lenders also routinely require that you sign an IRS Form 4506-T, Request for Transcript of Tax Return. This form will be used to obtain copies of the tax information you have on file with the IRS for the tax years in question. In using this form, lenders are confirming that the tax returns you’ve supplied match those filed with the IRS. This is an effort to prevent the use of fraudulent income tax returns so be aware that you may face unpleasant consequences if the IRS transcripts don’t support those tax returns.

Lenders can sometimes use the transcripts to verify your income, but they provide only summary totals and don’t reflect complete information from your returns. Providing the tax returns themselves usually results in a more generous qualifying income. For example, lenders will add back non-cash expenses, such as depreciation and amortization, which will reflect a higher income.

The business tax return requirement may be waived if the following apply:

  • You’re using your own personal funds – and no funds from your business – to cover the downpayment and closing costs
  • You’ve been self-employed in the same business for at least five years
  • Your individual income taxes show a pattern of steady increases in your income from self-employment over the past two years.

How Self-Employment Income is Calculated

In calculating your income from self-employment, lenders use your net business income and not your gross sales or revenues before business expense deductions.

This is an inherent problem for self-employed borrowers. When filing income tax returns, most self-employed people will do their best to lower their tax liability by minimizing their net income. But when applying for a mortgage, they’ll want to maximize their income.

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As noted in the last section, lenders will add non-cash expenses like depreciation and amortization to your net income. However, they won’t add back actual expenses, like deductions taken for cellphones, internet, or business travel.

The lender will also average your self-employment income. For example, if your net self-employment income in 2015 was $50,000, and $70,000 for 2016, they will recognize your income to be $60,000, or $5,000 per month

This is calculated as follows:

$50,000 (2015) + $70,000 (2016) = $120,000 divided by 24 months = $5,000 per month

There can be complications if your income is declining. If your 2015 net income from self-employment was $70,000, and $50,000 for 2016, the lender wouldn’t average your income over 24 months. Instead, they’ll recognize only your 2016 income, of $50,000, and average it over just 12 months. That will produce a monthly qualifying income of just $4,166 per month ($50,000 divided by 12).

The lower income will be used because your business is showing a pattern of declining earnings.

But that’s the optimistic outcome. A lender may reject your self-employment income entirely if they determine that the declining trend might lead to your business failing.

Using Business Assets for the Down Payment on the New Home

If you are withdrawing money from your business to cover your down payment or closing costs, the lender will have to evaluate the effect of that withdrawal on your business.

For example, the lender may request verification of all of your business’s financial assets to assess the impact of the withdrawal. The determination will be different in each case. For example, if your business has $100,000 in cash assets, and you need to withdraw $10,000, it may not be an issue. But if you only have $15,000, the survival of your business may be compromised.

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In that situation, the lender will likely request a written opinion from your CPA on the effect of the withdrawal on the business. If the CPA indicates that the withdrawal won’t hurt the business, the lender may allow the withdrawal. But if the CPA indicates any concerns, or refuses to comment, your loan approval may be reconsidered.

If you’re self-employed, it’s important to provide the necessary documentation and to do so as early in the loan process as possible. (Read more about this at our post “Ultimate Guide to Getting a Mortgage When You’re Self-Employed” for more) The lender isn’t looking to hassle you or to decline your loan. But they will need your help in supporting their decision to approve your loan. You’re helping your own cause by being fully prepared to cooperate.

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