Before You Become Self-Employed, Get Your House in Order

Technology advances and the Affordable Care Act have worked together to create a business environment where more people than ever can make a great living as a self-employed worker. Companies like Elance and Odesk provide ample opportunity for graphic artists, web designers, and even lawyers to work on a freelance basis. The Affordable Care Act has emancipated workers who were tethered to their company-provided health insurance policies due to pre-existing conditions.

If you have been thinking about taking a shot at working independently, we strongly recommend that you get your mortgage in place (or refinanced) before you take the plunge. This is due, in part, to the Consumer Financial Protection Bureau’s rules that came into effect on January 1, 2014 as part of the Dodd-Frank lending reforms. These rules set up standards for “qualified mortgages.” Qualified mortgages are those that (a) require the lender to take certain steps to assess the borrower’s ability to repay the loan, and (b) do not have certain features that increase the likelihood that a borrower might get in trouble (such as negative amortization or interest-only repayment terms). Qualified mortgages can be purchased by Fannie Mae and Freddie Mac, which is attractive to mortgage lenders because this transferability increases liquidity and decreases the risks inherent when the lender has to hold a mortgage in its own account.

For a mortgage to be a qualified mortgage, the lender must verify and confirm the borrower’s income. What will be required to establish income? Lenders generally require two (2) years of personal and business returns (although some will require just one years’ return). If you have filed an extension or if your last tax returns were filed over six (6) months ago, lenders may also require a profit and loss statement for the business for each quarter that has elapsed since the date of the last tax return.

The lender will be looking at your net income – which means that all of those expenses that were deducted to reduce self-employment income will be netted out, thus potentially reducing your income for borrowing purpose to make you a much less attractive mortgage candidate. Your income for the two tax years preceding the date of mortgage application will be averaged if the trend over time shows an income increase. A declining trend will require a letter of explanation. If the most recent years’ income is lower, then you will not get the benefit of averaging – they will consider the most recent year as indicative of your income.

If at all possible, get your home mortgage in place before you take the self-employment plunge!

If you are already self-employed and find yourself in the market for a new mortgage or need to refinance, here are some suggestions from mortgage professionals that might help you prepare:

1. Wait to apply for a new mortgage until you have two years’ of income under your belt.
2. Begin preparing in advance by not taking every single deduction so that you can show more net income on your tax returns.
3. If you are working on a long-term project, consider asking your client to bring you on as a W-2 employee.
4. To satisfy debt to income requirements, consider paying off bills to reduce the debt side of this equation.
5. Save up for the down payment. Keep the down payment savings in a personal account without a lot of activity, as lenders will want to verify the source of large depositis. The larger the down payment, the smaller the mortgage will be, and the more of a cash cushion the lender will have. Lower loan to value ratios make loan approvals easier.
6. Check your credit score and call the rating agency to clear up any mistakes. DO NOT CLOSE OLD ACCOUNTS!
7. Keep pristine paperwork, and consider beginning the practice of preparing profit and loss statements for your business.

 

CONTACT US

Please contact Marty or Chris at Spaces Real Estate Brokers so we can put you in touch with a mortgage professional who can guide you through this process.