How to Calculate Self-Employed Income for Mortgage Loans

The number of self-employed people has consistently grown in the last decade and now accounts for about 10% of the American workforce. Yet, a study by Freshbooks showed that nearly half of Americans want to be self-employed or own a small business!

While being self-employed comes with many perks and benefits, it makes some things more challenging, such as home-buying. To become a homeowner, self-employed borrowers must jump through many more hoops to secure a mortgage than the average worker. However, the process is not impossible; now is as good a time as ever to enter the real estate market. 

Let’s dive into how to calculate self-employed income for mortgage loans so you can begin the journey to homeownership today. 

Common Mortgage Requirements for the Self-Employed 

Typically, when filling out a mortgage application, you need to provide the following documents: 

• Bank statements and other assets 
• Credit report 
• Income tax returns 
• Proof of income such as pay stubs or W-2s 

However, to get a home loan when self-employed, you will need the following in addition to the documents mentioned above: 

• Business license (if applicable) 
• Business tax returns, including K1s and forms 1120 and 1120S 
• Explanation letter to discuss irregularities in income (if applicable) 
• Letter from your CPA 
• List of current clients 
• Profit-and-loss statement and balance sheet 
• Proof of a stable employment history for a minimum of two years 

When submitting your personal tax returns and proof of income, you will need to include IRS form 1040, all 1099 forms, and all schedules the IRS requires you to file, such as: 

• Schedule C: details income and losses from sole proprietorship 
• Schedule D: details capital gains income and losses 
• Schedule E: reports incomes and losses from leased and rented real estate 
• Schedule F: reports farming income 

For help calculating 1099 income for a mortgage loan, speak with your CPA. 

Identifying Types of Self-Employment Income and Documentation 

The self-employed can use several income sources to qualify for a mortgage. They include: 

• Business owner income 
• Limited liability company (LLC) 
• S-corporation 
• Sole proprietorship 
• Freelance and independent contractor income 
• Gig work and side jobs 
• Seasonal work 

Underwriters look at each self-employment structure differently, so the lender may require additional or different documentation based on your self-employment type. 

Mortgage companies use a complicated formula to identify qualifying income. They take your taxable income and add back certain deductions, like depreciation, that aren’t expenses from your bank account. Although it’s common for businesses and self-employed people to make many tax deductions to reduce their tax bill, this can negatively impact the ability to get a mortgage. 

Further, some sources of income do not apply to your monthly income. They are: 

• Disability insurance payments 
• Employer-provided insurance 
• Health savings account (HSA) 
• Inheritance and financial gifts 
• Life insurance payouts 
• Municipal bond interest 
• Roth account income 
• Sale of a principal residence 

Finding Your Net Business Income 

Mortgage lenders use net income, the profit you earn after deducting business expenses and permitted write-offs, not gross income, the total amount you make before expenses to determine your income level and eligibility for a home loan. Thus, knowing your net income is essential to calculate how much you can spend on a home. 

Simply take your total revenue and subtract expenses, interest, and taxes to identify your net income. If you have difficulty with the calculation, your CPA can assist you. 

Handling Declining Income and Extraordinary Events 

Many mortgage lenders will reject your application outright if they see a pattern of declining income. This is because they fear you won’t be able to make mortgage payments with less income. While you can refinance a mortgage, loan officers don’t encourage taking out a mortgage you will need to refinance because you cannot afford the monthly payments. 

Steady cash flow and a consistent average monthly income are the ideal scenarios when applying for a mortgage. If you cannot demonstrate such stability, it becomes necessary to provide documentation explaining why your income is declining and present a positive outlook for the future. You may not qualify for a mortgage if you cannot demonstrate that your income will improve. 

Fortunately, lenders will consider the effect of an extraordinary, one-time event. For example, if you’re a restaurant owner, the lender will understand your income was less in 2020 because of the pandemic and not hold this against your mortgage application. 

Accounting for Other Income Sources 

Many self-employed have one or two primary sources of income with additional income sources to support their main work. As long as each income source qualifies, the mortgage lender will consider it. Usually, they want to see if the income is ongoing, meaning it will continue for at least three years after the loan closes. 

Estimating Your Mortgage Approval Amount 

You don’t need to be a personal finance expert to know how to calculate your self-employment income for a mortgage. Just follow these steps: 

1. Calculate how much you make 
2. Identify how much you spend and your monthly debt 
3. Decide how much you will put down and how long your mortgage will last 
4. Determine interest rate 

Exploring Self-Employed Mortgage Options 

Several loan options exist for self-employed individuals, such as: 

• Conventional loans 
• FHA government loans backed by Fannie Mae and Freddie Mac 
• USDA loans 
• VA loans 

Eligibility for each loan program differs, so explore each option in depth to see if you qualify and if the loan is suitable for your needs. For example, most loans require a credit score of at least 620, but FHA loans only require a score of 580 (or 500 if you put down 10%). They are an excellent option for those with a spotty credit history. 

Tips for Improving Chances of Approval 

Here are some things you can do to ease the mortgage process and enhance your likelihood of getting approved: 

• Improve your credit score by making payments on time and paying down revolving debt like credit card balances 
• Lower your debt-to-income ratio (DTI ratio) 
• Make a larger down payment 
• Prepare for closing costs 
• Shop around for the right NMLS-licensed lender 

Following these tips won’t just make getting a loan easier. It will also help you get a better interest rate and loan term. 

Know How to Calculate Self-Employed Income for Mortgage Loans 

Now that you know how to calculate self-employed income for mortgage loans, you can apply for a mortgage today! 

If you have further questions about the loan application or the process for applying for self-employed loans, speak with a mortgage professional from The Associates Home Loan of Florida. Our team will happily assist with any inquiries you have.