Self-Employed Home Mortgage Loan: How Much Can You Borrow?
Learn how lenders calculate income, DTI, and down payment for self-employed borrowers, and what actually determines how much you can borrow.
Picture this: You're a self-employed home buyer looking to take out a mortgage loan. You know your credit score is good, you have a healthy down payment, and you've done a rough calculation of what you can afford.
But when you speak to your lender, they tell you that you can't borrow as much money as you thought you could. Why is there such a disconnect between your calculation and theirs? Are they looking at different variables, or is it something else entirely?
Don't worry! We're here to clear this up. This guide will give you an overview of what lenders consider when lending money to the self-employed, as well as tips on boosting your chances of getting approved.
So whether you're just starting your homebuying process or in the thick of trying to figure out how much you can afford, read on for the information you need!
TLDR Key Takeaways
- It can be difficult for entrepreneurs and self-employed individuals to determine how much they can borrow due to a lack of knowledge about bank underwriting guidelines.
- Several variables are used in calculating your borrowing power, and even the smallest change to one of them could drastically alter your final figure.
- Every calculation starts by determining your average annual income, which typically involves using two years' worth of tax returns, but these profits can vary from year to year and may not accurately reflect true business earnings.
Why Is It So Hard for Entrepreneurs and the Self-Employed to Calculate How Much They Can Borrow?
The simple answer to this question is that many self-employed borrowers don't know how banks and lending institutions will look at and calculate their income.
After all, you may have irregular income from different sources or fluctuating amounts each month for the same job. All of this makes it hard to know exactly how much you can borrow.
Traditionally, lenders follow underwriting guidelines to determine your borrowing power. They want to see:
- Proof of income
- Good credit score
- Low debt-to-income ratio (DTI)
- Reasonable down payment
Salaried employees must show paystubs or W2s as proof of income. But entrepreneurs and self-employed individuals typically rely on business tax returns to prove how much money they make.
The problem with that is your profits may be inconsistent from year to year or may not accurately reflect the cash flow of your business because you take advantage of write-offs during tax season.
Both of these problems will make it even more challenging to obtain a mortgage loan.
While there's not a one-size-fits-all answer, there are factors you can look at that will affect how lenders calculate your true borrowing power.
What Are the Factors that Influence How Much I Can Borrow?
The most common question entrepreneurs and self-employed individuals have when seeking a mortgage is: How do I accurately calculate how much I'm able to borrow?
The answer to this question is complex, as a number of variables are considered when calculating borrowing power, including:
- Income
- Debt-to-income ratio (DTI)
- Down payment
- Interest rate
Even the smallest change to one of these factors has the potential to fluctuate your calculation. Let's take a closer look at each factor and show you how it sways your borrowing power.
Income
Income is the cornerstone of every mortgage calculation, and this is where many self-employed individuals get caught up.
Now, if you're like most self-employed individuals, you like to take advantage of every write-off you can. While that's beneficial for you at tax time, it's not the best when you qualify for a mortgage.
Why? Because most lenders typically look at two years worth of tax returns to measure average annual income. Depending on your lender, they can use your net or gross income, and which one they use has a huge impact on your overall borrowing capacity.
For example, let's say a borrower grosses $120,000 per year and reports $84,000 on their tax return after all their deductions. This gap between gross and net income is illustrative; the actual effect on a loan amount depends on the lender's guidelines and current rates, so treat any dollar comparison here as an example rather than a guarantee.
Debt-to-Income Ratio
The DTI is a formula used to determine how much of your monthly income goes toward debts and liabilities. It's usually expressed as a percentage.
It's a way for the lender to gauge how much risk they are taking by lending you money, as it helps them see what kind of financial shape you're in prior to taking on a mortgage. The CFPB explains that lower DTI ratios generally indicate less risk to lenders, though acceptable thresholds vary by lender and loan program.
Generally speaking, lenders prefer lower DTIs, though some are willing to approve higher ratios depending on compensating factors like credit score, reserves, or down payment size. The specific loan amount difference between a lower and higher DTI depends on income, rate, and down payment, so speak with a loan officer for numbers specific to your situation.
Down Payment
The size of your down payment also impacts your borrowing capacity. Down payment requirements vary by loan program and lender, and putting down more than the minimum can reduce the amount you need to borrow and ultimately increase your borrowing power.
For example, if you have a 20% down payment on a $500,000 loan amount, your total loan-to-value ratio will be 80%. However, if you have a 10% ($50,000) down payment, then your loan-to-value ratio will be 90%.
Interest Rate
The interest rate you qualify for is based on your credit score, income level, and the loan-to-value ratio.
Borrowers with higher credit scores tend to get better rates, while those with lower scores will usually have to pay a higher rate. This reduces their borrowing power as the payment amount increases at a higher rate.
The examples below illustrate how rate differences affect a monthly payment; actual payments depend on the rate, term, and loan amount you're quoted at the time of application. For instance, a higher rate on a given loan amount and down payment will produce a higher monthly principal and interest payment than a lower rate on the same terms, which can reduce how much loan amount you qualify for overall.
Tips to Boost Your Mortgage Borrowing Power as a Self-Employed Individual
For self-employed individuals looking to secure a mortgage, there are several steps you can take to make the process easier. Here are some tips that will help boost your borrowing power:
- Organize Your Proof of Income: Make sure that your financial records are up-to-date and organized, including two years of tax returns and recent accounting statements. This will make it easier for lenders to get an accurate picture of your financial situation and give you a better chance of getting approved.
- Have a Good Credit Score: Your credit score is essential when applying for a mortgage, so you must keep up with making payments on time and managing your debt.
- Verify Your Expenses: Ensure you have the documentation needed to show all of your expenses, such as profit and loss statements.
- Build Cash Reserves: Some lenders require a specific amount of cash reserves for you to qualify for a loan. Having enough money set aside in case of an emergency will make you appear less risky to lenders.
Remove the Guesswork with Modern Day Lending
At Modern Day Lending, we understand that being self-employed isn't always easy, especially when it comes to getting approved for loans. This is why we make our calculations and pre-approval process as transparent as possible.
Our team of experts has extensive experience in helping self-employed workers understand the loan amount they may be eligible for at competitive rates.
With us, you don't have to navigate the traditional complexities associated with self-employed home loans alone. We can help assess your current financial situation and outline what loan amount you may be eligible for.
All you need is:
- 12 - 24 months of bank statements (business or personal)
- A letter from your CPA stating your ownership percentage, that you have been self-employed for at least two years, and that your business is in good standing and operating
- Completed Business Questionnaire form
- Two months' personal asset statements
- Driver's license
You deserve to have a stress-free experience when it comes to obtaining a self-employed home mortgage loan, and we're here to make that happen.
Get in touch with Modern Day Lending today to discuss the loan amount you may be eligible for as part of your homebuying journey.
