Imagine having an 800+ credit rating and no debt (including no mortgage loan), making a decent yearly income from freelance work and stock investments….and yet still being declined for a mortgage. Yep, that’s what happened to me- even after I was pre-approved for my mortgage loan based on my last two years’ AGIs (adjusted gross incomes). What gives?
If you are a freelancer, and especially if you have recently become a freelancer, be aware that you will probably NOT qualify for a mortgage loan, home equity loan, or even a personal loan.
Self-employed = unemployed
Banks and other lending agencies are hard set to trust traditional employment as an assured source of future income- even if you get fired or laid off tomorrow. Self-employed individuals have taken a risk by starting their own businesses and finding their own clients, and this is often reflected in their wildly fluctuating income statements. As a whole, self-employed folks are more likely to fail and then become unemployed altogether.
Finally, although never openly stated, many bankers and loan officers associate the term “self-employed” as code for “I can’t find a job.”
Self-employed = low income
Another reason why self-employed individuals are denied for loans is because they don’t make enough money- at least on paper. Yet, according to data published by Zillow, self-employed individuals actually make a lot more money than employed individuals. Furthermore, self-employed individuals have seen a substantial increase in their earnings since 2012, while employed individuals have seen a decrease.
However, in an effort to save money on taxes, most self-employed people also write off their business expenses. This saves a bundle on income tax- but it also lowers net income.
Net income is critical because loan officers use it to calculate your debt-to-income (DTI) ratio, or your monthly housing costs and other debts compared to your net income. A loan applicant’s DTI ratio can be no higher than 43%.
Self-employed = always self-employed
Some freelancers transition gradually into self-employment, working with clients and for employers at the same time. They do this for several reasons, including insufficient client work, employer-based training/education, etc. Also, many employers nowadays will offer employees and independent contractors the option of working from home and/or setting their own work hours, making employment seem very much like self-employment.
You may not care whether your final earnings are reported on a W-2 or a 1099, but your loan officer will. In fact, once you declare yourself to be self-employed on your loan application, your employed earnings will not count towards your net income (unless you’re still employed with that employer).
In my case, because I was employed over a large portion of one of the years I reported to my loan officer, I was told that I made only $286/month for that year. If only the IRS believed that I made such a low figure!
Self-employed = no mortgage?
If you just started your own freelance business or have resigned from your employed job, it may seem like you’re doomed to not qualify for a loan until you earn mountains of cash each year (at which point, why would you even need a loan?). Luckily, it’s not impossible to get a mortgage loan- but it will be harder.
Understand that your ability to secure a mortgage loan, or any loan for that matter, depends on three factors:
Ability to repay + credit score + collateral
Ability to repay.
This is mostly based on your DTI ratio. For employed persons, DTI is calculated using the gross earnings from their last two years of pay stubs. Freelancers and the self-employed don’t receive pay stubs, so their last two years of tax returns are used to calculate the DTI ratio instead.
The problem with using tax returns is that net income after business deductions is calculated, not gross earnings. This is where freelance income is unfairly penalized compared with that of employed persons.
Most lending agencies are not going to approve your loan if you have a credit score below 680 as a self-employed freelancer. Call it discrimination, but that’s just how it works. As an employee, you stand a far better chance of securing a loan despite your low credit score, even if you do end up paying a higher APR.
This can consist of liquid assets, a pension or other regularly distributed income, and/or your home.
Given the variables used above to calculate your ability to secure a loan, here are the steps you should take at least six months to one year in advance of asking for money from a lending institution:
1. Improve your credit score.
While you have the time, ask for a copy of your credit report and find out how you can improve it. Try to achieve a credit score of at least 740, which will significantly improve your approval odds, as well as lower your loan APR.
2. Amend your taxes.
If you took significant deductions in one year on business expenses, consider amending your returns and spreading those costs out over several years- or even not reporting your expenses at all. This could cost you in extra tax, though.
3. Choose your tax years.
You can also, to some extent, choose which tax years your loan officer sees. Typically, you are required to show your last two years of tax returns. However, if you are applying for a loan early in the year, before you have filed your April taxes, you could go back two years before the current tax year. Then, if you find your net income from those years is too low, you could quickly do this year’s taxes and take the two more recent years into account.
Basically, applying for a loan early in the year means you can pick your two best earning years out of three.
4. Pony up a big down payment.
Even if your loan officer tells you to apply for 10% down payment loan, don’t. Save up enough cash so that you are putting down at least 30% on your mortgage loan. If you’re applying for any other type of loan, reduce how much you need to borrow as much as possible.
5. Work with an accountant now.
Get an accountant involved early on and have her calculate what your DTI ratio would be given your current and past net earnings. Discuss ways you can raise your net income or lower your current debts.
6. Obtain contract verification from all your clients.
Request contract verification from all your clients now, before you even set foot into a bank or apply for a loan online. Make sure your verification letters state how much you are earning with each client and how long you’ve been contracted with them. Having such letters ready to go and to supply to your loan officers will save you weeks of time (and aggravation) during the approval process.
7. Find a contractor-friendly lending institution.
With more and more individuals becoming self-employed or performing at least some freelance work, certain institutions are taking notice. Type “self-employed mortgage” into Google and you will locate online banks and other lenders that work with self-employed persons. Some cases in point are Vancity, a Vancouver-based credit union, and Freelancer Financials, based in the U.K.
8. Find a broker who specializes in self-employed loans.
A broker can go submit your income and other information to several lenders at a time. This saves you the hassle of constantly applying for loans and having multiple hard inquiries show up on your credit report- which ultimately lowers your credit score (I lost 0.9 points/hard inquiry). A broker can also provide you with advice on how to best submit your income and other variables.
However, you need to find a broker who regularly works with freelancers and the self-employed. Otherwise, you will be wasting your time with someone who knows about W-2’s….and not much else.
9. Apply at state banks and/or credit unions.
Traditional and national (i.e., “too big to fail”) banks typically work within Fannie Mae/Freddie Mac loan regulations, which are skewed in favor of W-2 applicants. State banks and credit unions are more independent and needn’t comply with such government-imposed restrictions.
10. Consider creating an annuity.
Annuities have long been touted as something for retirees who need a fixed income. However, if you have some liquid assets, you may wish to create an annuity with your bank and have it pay you on a monthly basis. This guaranteed monthly payout raises your net income. It does cost money to create an annuity account, however.
Being a self-employed freelancer is great in many respects, namely, choosing my own hours and clients and never getting bored with my work. But there are certain aspects to being self-employed that aren’t that great. It’s tough to secure a loan as a freelancer, and the mountain of documents you must supply is maddening. I now realize that I will need to track my income and expenses more closely. I will also need to invest much more time and effort into obtaining a loan in the future.
Still, what doesn’t kill me as a freelancer only makes me stronger. And then I get to write a blog post about it.