Mortgages and the Self-Employed (Scott McElmurry Commentary)

Financial independence — the knowledge that you, not a corporation, control your economic destiny — is an empowering feeling and a huge motivating factor for people who become self-employed.

According to the National Association for the Self-Employed, 77.6 percent of small businesses in the United States have no employees. That includes freelancers and micro-business owners. And, yes, the self-employed have a certain amount of control as to how they make their money, how much they charge and how they invest in the company. But unless you created a multibillion-dollar social media app, your economic destiny is never entirely under your control. That’s because most lending institutions have very specific requirements. Mainly, if you work for yourself, you’ve got to prove that your business can consistently make a profit. This is particularly true when asking for a home loan.

If you’re thinking about starting a business, you should probably put any house-buying plans on hold for a few years. Here are some special circumstances of which you should be aware.

Deductions: The Catch 22

Reducing your gross taxable income via business deductions is standard practice in the self-employment world. Odds are you look for every deduction available for your business. And who can blame you? You don’t have a company supply closet or corporate card available to cover the costs of doing business. You have to pay for every office staple, including actual staples. But by reducing your gross annual income you might also be reducing your chances at a larger loan. Self-employed borrowers are required to show documented IRS tax returns from the past two years. So banks are looking at your taxes, not just your in-house books, when determining how large a loan you can receive and the terms under which you’ll pay it. You’ve got to weigh which works out best for your situation.

Business Cycles: The Down Side of Ups and Downs

A lot of self-employed people have certain times of the year when their business is booming. Think lawn care. And if you’re looking to purchase your own plot of land, one busy season won’t cut it. Mortgage lenders want to know that you’ll be able to make your payments year-round. A robust savings account can help tremendously in this situation.

The ups and downs of business also convey how income is calculated. Typically, an average of the two most recent tax returns is used. However, if the most recent year shows a large decline from the previous year, it is likely the average can no longer be used. Income would then be calculated based on the worst or most recent year. But what if business has really taken off? Income would not be based solely on the most recent “great” year, but would be averaged with the previous year, possibly lowering income substantially if there is a large difference between the two most recent years. Confused yet?

In reality, the most conservative approach to income is typically preferred. If business income is declining, the lower income numbers are used. If it is increasing or stable over the past two tax returns, an average of the two years is considered.

Rating the Rates

Mortgage rates are starting to rise, but they are still at historically low levels. Just like other borrowers, the self-employed are in a great position to buy a new home or refinance their existing loan. The rules for the self-employed have changed from the excesses experienced in the past. “Low doc” or “stated income” loans are a thing of the past. The self-employed need to be ready to supply their tax returns for the past two years and possibly a current profit and loss statement with the understanding that they will be judged based on the income they reported to the government. Increased documentation is the new normal in the mortgage arena. If you go into the process expecting an IRS audit, you’ll be pleasantly surprised.

The bottom line is that before you’ll be able to sign the bottom line on a mortgage loan, you have some work to do. But the fact that you have taken the leap to work for yourself means you are more than capable of tackling the challenge.

Scott McElmurry is president and CEO of Bank of Little Rock Mortgage. His website is BLRMortgage.com and his email address is SMcElmurry@BLRMortgage.com.