How to calculate self-employed income for mortgage loans
To qualify for a mortgage and buy a home as a self-employed borrower, you must show lenders that you have a steady income.
Proving your income as a solo operator might sound like a massive headache compared to employees who just have to provide a W-2, but don’t stress!
Modern lenders are used to working with all kinds of non-traditional income situations. It’s becoming more and more common.
Even if your income comes from a bunch of different side hustles, lenders have figured out how to make it work. You just need to put in a little extra effort on the paperwork.
This article explains how underwriters calculate and qualify self-employment income when reviewing mortgage applications. Read on to learn what’s needed to present your best case.
What lenders look for in self-employed borrowers
To qualify self-employed borrowers, lenders dig into your financial history looking for:
Two years of self-employment - Lenders want to see you've been successfully self-employed for at least 24 months. This demonstrates stability in your profession…much like your 9 to 5 peers who punch in, then try to resist flipping their cubicle neighbor’s desk for the next eight hours.
Stability - Lenders mainly want to see that you have reliable income streams, so they look at your IRS 1040 forms, including all schedules, such as Schedule C and Schedule E.
Steady earnings - Underwriters look for consistent income over two years with no major fluctuations or losses. Large drops may indicate inconsistent business.
Continuing income - Proof is needed to show your income stream will likely continue for at least three more years. This ensures you can keep making mortgage payments.
This can be tricky, but rather than channel your inner Series A funded startup with celestial growth projections, rely on historical data and talk to your underwriter for help if you need it.
Strong credit - A higher credit score helps offset the increased risk of self-employed loans. Good credit also indicates financial responsibility.
Low debt-to-income ratio - Your total monthly debt payments divided by gross monthly income should ideally be below 36%. The lower your DTI, the better.
Providing documentation to satisfy underwriters on these points is crucial to qualifying as a self-employed borrower.
What income do mortgage companies look at for self-employed borrowers
You might be wondering, how is self-employed income calculated for mortgage loans? What counts and what doesn’t?
The answer lies within your tax returns.
Self-employed individuals report earnings on Schedule C of IRS Form 1040 submitted with annual tax returns.
If you’re wondering how to calculate self-employed income for mortgage loans or how to calculate 1099 income for mortgage loans, here’s a basic breakdown:
- Add up Schedule C net income from the past two years
- Divide the total by 24 months
This answers the question how is self-employment income calculated for a mortgage? Now take a look at the example below to see the calculation in action:
As a real estate agent, Sarah files Schedule C tax forms annually to report her self-employment income from sales commissions and other revenue.
To determine Sarah's average monthly income, the lender will add up her Schedule C net income from the past two years:
Year 1 Schedule C net income: $100,000
Year 2 Schedule C net income: $110,000
$100,000 + $110,000 = $210,000 total net income
Next, they divide the two-year total by 24 months:
$210,000 / 24 months = $8,750 average monthly income
This shows Sarah's earnings history while accounting for growth in her real estate business. The lender uses 24 months to calculate a monthly average, smoothing out any fluctuations.
The same method applies for self-employed borrowers in all professions using Schedule C income. By crunching the numbers on two years of tax returns, lenders can qualify and underwrite loans for self-employed applicants.
If your income fluctuates, lenders may base calculations on your lowest earning year. Declining revenue poses a higher risk.
Another thing to remember is that keeping your personal money separate from your business money makes getting a home loan much smoother because it’s easier for everyone to follow the paper trail.
At the end of the day, learning how to calculate self-employment income for mortgage loans is simple math, so try not to let yourself get too anxious about it.
What income sources count?
Along with self-employment revenue, lenders consider other steady sources that can help you qualify for a bigger mortgage amount:
- Investment income like dividends and interest
- Rental income from investment properties
- Retirement accounts like 401(k)s and pensions
- Spousal income if your spouse or partner also works
- Child support and alimony
Adding other steady sources of income to your self-employed earnings can help you qualify for a lower-interest mortgage with better terms.
Documentation needed to verify income
The basic rule of thumb is to go armed with every single document needed to prove your income, assets, and credit profile. More is better, in this case. Don’t start collecting your Costco receipts, but do look at providing extra documentation to validate your income, including:
- Two y ears of personal and business tax retuns
- Current year profit and loss statement
- Balance sheet
- Bank statements
- Business licenses and incorporation documents
- Accounts receivables report
- Projections report
- Business credit report
While being your own boss has incredible perks, it can make getting a mortgage a pain if you don't have your finances squared away.
Try to collect all the documentation you can, and be transparent with your loan officer if you have complex income streams. They will work with you and find you an underwriter who is an expert at how to calculate self-employed income for mortgage loans.
With proper preparation and an understanding of how lenders evaluate your income, self-employed borrowers can confidently get approved.