Net or Gross Income: How Lenders Qualify Self-Employed Borrowers

The home buying process has evolved over the years, but one thing will never change: Your income will be one of the main factors mortgage lenders will look at when determining your borrowing power.

And if you're one of the millions of self-employed individuals in the United States, according to Bureau of Labor Statistics data, you might wonder whether your lender will use your net or gross income. Because let's be honest, this can make a significant difference in the amount you qualify for.

While there's a lot of conflicting information surrounding this topic, we're here to help clarify things and explain how mortgage lenders determine self-employment income.

Do Mortgage Lenders Use Gross or Net Income for Self-Employed?

While there are several programs out there that allow lenders to use your gross income to qualify you for a mortgage, generally speaking, most lenders will use your net income (or income after business expenses are deducted).

Why?

Because many traditional banks follow underwriting guidelines that call for using the taxable (net) income listed on a business tax return, it's viewed by those lenders as a more accurate reflection of earnings since it shows income after expenses are paid.

However, that's not necessarily the best measure for every borrower. For self-employed borrowers who take advantage of legitimate write-offs or who have high business expenses, this approach can lower their overall borrowing capacity.

Depending on the lender's specific guidelines for self-employed borrowers, some can look at both gross and net income to determine your eligibility.

When Would a Lender Use Gross and Net Business Income?

The answer to this question largely depends on the lender's assessment of the borrower's ability to repay the loan.

There are a few different scenarios in which a mortgage lender may consider both gross and net income to qualify a borrower, such as:

• The borrower is self-employed (1099, subcontractor, freelancer, etc.)
• The borrower has multiple sources of income (rental income, investment income, child support, etc.)
• The borrower has a high amount of deductions on their taxes

In each case, lenders will analyze the borrower's income information to help determine loan suitability and repayment likelihood.

By reviewing both gross and net income, a lender can develop a fuller picture of the borrower's financial situation to inform an underwriting decision.

If you are unsure which income figure your lender will use, it is best to ask in advance so that you can be prepared with the necessary documentation.

How Is Self-Employed Income Calculated for a Mortgage?

Self-employed income can be trickier to calculate for a mortgage than traditional employment income since there's often more variability in earnings.

Lenders will typically start by calculating an average monthly income using a two-part formula. It looks like this:

Part 1

(Year 1 Earnings + Year 2 Earnings) / 2 = Average Annual Income

Part 2

Average Annual Income / 12 = Average Monthly Income

Let's break that down. For example, say in your first year you earned $75,000, and in the second year, $100,000. A lender might add those two together and divide by 2, like so:

($75,000 + $100,000) / 2 = $87,500

From there, they would divide that number by 12 to estimate an average monthly income, like this:

$87,500 / 12 = $7,292

Once they have this number, they'll factor in the debt-to-income ratio (DTI) to help confirm there's enough income left over to cover mortgage payments alongside existing debt. They use another two-part formula like this:

Part 1

(Average Monthly Income x DTI) = Maximum Allowable Debt per Month

Part 2

Debt per Month - Existing Expenses = Maximum Mortgage Payment

Let's continue with that example. Say your average monthly income is $7,292, and for demonstration purposes we'll use a 36% DTI as a cap:

$7,292 x 36% = $2,625

That means $2,625 would be the maximum amount of debt allowed per month in this scenario, including the mortgage payment. So if monthly expenses total $700, the maximum mortgage payment in this example would be $1,925.

A few things are worth noting here:

1. Allowable DTI limits vary by lender and loan program; borrowers should confirm current limits with their lender rather than assuming a fixed cap.
2. Higher monthly expenses reduce the maximum mortgage payment a borrower may qualify for.
3. Depending on the lender and program requirements, they may use average net or gross income, and the choice can make a substantial difference in this calculation.

What Else May You Need to Qualify for a Mortgage as a Self-Employed Individual?

On top of your income, there are a few additional things you may need to qualify for a mortgage, such as:

• Bank Statements: Rather than relying solely on tax returns to prove income, some lenders review 12 to 24 months' worth of bank statements as part of a bank statement loan program.
• CPA Letter: This letter from your accountant typically states the percentage of the business you own, confirms the business is in good standing, and confirms you have been self-employed for a specified period, often at least two years.
• Business Questionnaire Form: This is a set of targeted questions to help lenders understand details about the prospective homebuyer, the property they're interested in, and their eligibility for repaying the loan.
• Cash Reserves: Lenders often require a minimum amount of cash reserves for self-employed borrowers, though the exact requirement varies by lender and loan program.
• Personal Asset Statement: Lenders may require a personal financial statement covering a set period, often at least two months' worth of documentation, for the business's assets and liabilities.
• Driver's License: This will be used to confirm your identity.

Get the Guidance You Need with Modern Day Lending

We know self-employed borrowers often have unique financial situations that traditional big banks won't accommodate, which is why we'll work closely with you to understand your needs and find the right loan for you.

Self-employed mortgages can be more complicated to qualify for than traditional mortgages, but that doesn't mean they're out of reach.

We have a deep understanding of underwriting guidelines that allow us to tap into a wide range of programs, so we're positioned to help find one that meets your specific circumstances.

If you have any questions or want to learn more about our programs, reach out to a member of our team. We're here to help!