Plenty of Americans have that entrepreneurial spirit. Being your own boss and setting your own hours is liberating, and millions of Americans have made the leap. But there are special credit challenges to be aware of, especially in the first two years of striking out on your own.
Self-employed Americans by the numbers
According to a 2014 report from the Bureau of Labor Statistics, 14.4 million Americans are self-employed. (When you factor in part-time independent workers, that number is even higher.)
According to a 2015 report from MBO Partners…
- There are 30.2 million independent workers aged 21 and older who work full time or part time doing everything from freelancing to independent consulting
- The number of independent workers is expected to rise to 38 million by 2020
America’s self-employed and independent workers produce $1.15 trillion in revenue every year, according to MBO Partners.
And 45 percent of independent workers report making more money than they would in a traditional job.
Impact on credit when purchasing a home
But despite earning more money, self-employed Americans may have a more difficult time qualifying for a mortgage.
According to Zillow.com:
- Self-employed mortgage shoppers earn roughly 80 percent more than non-self-employed shoppers (and they seek more expensive homes).
- Yet self-employed borrowers receive only six or seven quotes for every 10 mortgage quotes received by borrowers who are not self-employed.
Lower credit scores
Lower credit scores has become the key stumbling block for many self-employed mortgage shoppers. Self-employed mortgage shoppers are about twice as likely as non-self-employed shoppers to report a FICO score of less than 680, according to Zillow.com.
In October 2014, 28 percent of self-employed mortgage shoppers on Zillow reported a credit score of less than 680, compared to 14 percent of non-self-employed mortgage shoppers.
Even though the self-employed have higher incomes, their incomes are also more volatile and more difficult to document compared to salaried workers, says Zillow.com.
“People who are self-employed tend to not have as equal income as W-2 workers,” agrees Dick Lepre, senior loan advisor at RPM Mortgage, Inc. in Alamo, Calif.
A big dip in year-to-year income will raise plenty of questions from a mortgage lender.
“Volatility is always something that is going to require an explanation,” advises Lepre, who recommends providing a mortgage lender with a letter of explanation detailing why the self-employment income went down and why it’s not going to go down again in the future.
Lower tax bill, bigger credit challenge
In addition to year-to-year income volatility, many self-employed people take numerous deductions on their federal tax returns, too, helping to lower their tax bill but also lowering their income and making it more difficult to qualify for a mortgage.
“Self-employed people tend to take substantial deductions on their Schedule Cs,” Lepre says. “They end up bashing income down for paying as low as taxes as possible, making it more difficult to qualify.”
Lacking self-employment history
If you try to apply for a mortgage with less than two years of self-employment history, you can forget about qualifying. “It’s fatal in the short run. You literally can’t qualify for a mortgage,” counsels Lepre. “Self-employment income can only be counted when you have two years of federal income tax returns.”
So hang on to the salary job just a little bit longer if you plan to buy real estate in the next two years. Otherwise, you won’t be able to qualify for a home loan, even if your income is comparable to your 9-to-5 job. “The self-employed person needs to plan ahead,” Lepre adds. “Don’t quit a W-2 job and go to self-employment if you are going to buy real estate in the next couple of years.”
In addition to two years of federal income tax returns, both personal and business, a self-employed person may need to provide a mortgage lender with two months of personal and business checking account statements plus information on investment accounts when they apply for a mortgage. “Generally, we are looking for investment accounts if personal checking and savings accounts don’t supply enough in reserves,” Lepre says.
What tax returns tell
Joseph Kelly, president of Arcloan, stated that “It is definitely more challenging because there’s a lot more documentation, more hoops to jump through,” for a self-employed person to qualify for a mortgage.
“Mortgage lenders will take a close look at what a self-employed borrower is writing off on their tax returns for their business and their business profits and losses,” says Kelly.
Because of all the documentation needed, Kelly recommends self-employed mortgage shoppers start the home loan process as early as possible.
“The bottom line is it’s just a lot more paperwork,” Kelly says. “Do it as early as possible so you’re not under some time crunch.”
Kelly also recommends self-employed borrowers check out mortgage lending opportunities from a smaller community bank or credit union where they may already do business. “Those people can be a lot more flexible in looking at your finances,” Kelly says.
As for auto loans and credit cards, self-employed borrowers can relax. “Most of those types of lendings are based on FICO scores,” Kelly explains, so there’s whole lot less paperwork involved.