But there are other significant barriers and challenges to self-employment. The one I want to talk about today is obtaining a mortgage. People considering making the switch from corporate to self-employed should consider this: It’s far more difficult to obtain a mortgage as a self-employed individual.
So, before you jump out of a stable corporate W2 position, think for a bit about whether you might want to do any of these things soon:
- Buy a house via a first mortgage;
- Refinance your house;
- Pull some equity out of your house (e.g., a cash-out refinance);
- Pursue any other kind of mortgage or significant loan (such as a second home or an investment property acquisition).
If any of those apply to you, I’d advise you to think ahead before making that jump.
The Main Issue Is Your Income
The mortgage industry views corporate W2 income as almost guaranteed money. But if you’re on your own as a self-employed individual, they’re suddenly highly leery of your income, even if it’s fairly stable in nature.
One common problem is that you may find that the income level you think you’re at isn’t what lenders use for their calculations during underwriting. They want the net, not the gross, and that’s a trickier calculation that just looking at a box on your W2.
Let’s say that, like me, you’re a web developer. For me, I absolutely need fast Internet as part of my business. And, fortunately, I have gigabit Internet, which runs me about $100/month. And so I write that off on my taxes as a business expense (because, of course, it’s a legitimate expense).
But that single item lowers my “income” (as reported on my taxes) by $1,200 annually. And nice as it is to qualify for such a deduction, it doesn’t take many items like that to make your “income” (for mortgage underwriting purposes) appear much lower than it actually is.
And, by the way, people who aren’t web developers probably also buy Internet service, but it’s not held against them when applying for a loan, as it’s not considered a debt or a necessity. So, this is just one example of how self-employed people can sometimes appear poorer on paper than they actually are when compared to others.
Another common issue is that mortgage underwriters will want you to have at least a two-year track record in your self-employment. I don’t know what might happen if you quit a full-time job, start a business, become successful in the first year, and then decide to try to obtain a mortgage. But, I suspect it would present headaches. Keep that in mind!
Other Income Weirdness & a “Secret” Tip About Debt
A bit of a tangent here, but…. Part of my own self-employment / entrepreneurial business was taking on boarder income (meaning, we rented out rooms in our house). Seemed like a good idea and “easy” income, though it meant more paperwork and tax filings. But, guess what? That income does not count in calculations of your debt-to-income ratio when trying to get a mortgage or refinance. (It counts perfectly well as far as the IRS is concerned, naturally— just not other parts of the government like Fannie Mae. Go figure.)
There are actually a handful of types of income that often don’t count for mortgage purposes. I only mentioned this one because being a landlord is a common form of self-employment. (There are some important distinctions and exceptions to this, of course, so I recommend further research if you think it applies to you.)
Also of note here is that the flip-side of income is of course debt. One thing I noticed during all of this mortgage business is that, when they pull your credit score for determining your debt-to-income (DTI) ratio, your business credit cards balances don’t seem to affect underwriter calculations (if they’re seen at all, which I don’t believe they are).
Ergo, aside from my other various comments in this article about mixing business and personal accounts, if you’re holding onto some personal CC debt (or expect to incur some during the mortgage application process) and are concerned with how it might affect this calculation, consider using a business CC for those purchases. I can’t verify 100% that this completely avoids all impact on DTI calculations, but one mortgage officer kinda-sorta gave me the secret winky-wink on this one. So, it’s a small way to game the system a little.
About Your Documentation
Another tricky thing is your documentation (bank statements, business licenses, tax returns, P&L statements, etc.). Corporate W2 job holders have it easy — just turn over some tax returns and pay stubs. For the self-employed, it’s a whole other ball game, and you run into quirky little issues during the process. For example, while attempting to obtain a refinance on my home, an underwriter gave me gruff about my using my business checking account to make payments on my personal credit cards.
“Why would I not do that?” I asked. After all, my business is, simply, a single-member LLC. All of the money in my business account is reflected in my personal tax return as my own personal money. My business’ money is my own, quite literally. I honestly see no reason why I can’t use it however I choose. (And indeed, there is no legal reason preventing me from doing so.)
But, some underwriters don’t see it that way. I can’t articulate their views, of course, but suffice it to say that, if you’re interested in obtaining a mortgage while self-employed, the more you can separate business from personal with respect to your bank accounts, the better. Though, I still think it’s impractical to, say, transfer business funds into a personal account before paying a personal credit card bill.
COVID Challenges
Speaking of documentation… As quick as the country was to give away trillions of dollars to big businesses during the pandemic, they were equally quick about locking down capital from the smaller guys. (As the saying goes, the U.S. is actually “socialism for the rich; capitalism for the poor.”)
For the self-employed, Freddie Mac / Fannie Mae rolled out some new and exciting additional requirements. For example, your previous two years of tax returns (previously all that was required) won’t cut it anymore. They want current financials and current bank statements.
And that’s all understandable, but I think it can be tough for some people with cyclical income. For example, during my own application, I was involved in a large project that paid out every couple of months. So, while June may have been a “down” month, July turns out to be an “up” month.” Frankly, I don’t think they have the ability to factor such fluctuations into their algorithms.
One bank also said that my P&L statement might need to be “audited.” Now, I used to work for Deloitte as well as another CPA firm. So, the word “audit” to me might mean something different to me than what it means to a bank underwriter. I’m not sure how a CPA “audits” a bank statement, or if that even is the correct term for such an engagement.
What I do know, however, is that it’s not going to be cheap to have a CPA spend a couple days paper-trailing your entire business check register and then signing-off with some kind of professional assurance sought by a bank. So, here again, being self-employed can also easily translate into higher costs, as almost no corporate W2 workers would be required to jump through this (potentially multi-thousand-dollar) hurdle.
NON-QM Loans & Bank Statement Mortgages
If you have trouble with conventional mortgages as a self-employed individual, you may come across some alternatives. I’d never heard of these until a mortgage broker mentioned “SIVA” to me in passing. Turns out it means “Stated Income / Verified Assets,” referring to alternative types of loans.
I’m still new to this area and am exploring the options. It seems that, more commonly, they’re found online under terms like Non-QM (non-qualified mortgage) loans or bank statement loans. These are basically loans that cater more toward those who might look worse on paper than they actually are. Instead of looking at tax returns, they look at bank statements or even other verifiable assets in considering loan-worthiness.
So far, I’m not super-excited. As much as they may be better for self-employed people, I think the amount of research it may take to find the best one might be significant. For one, there seem to be fewer standards as to how they count income (which is a good thing, potentially, but also means you may need to shop around considerably).
Many I’ve seen, for example, look at your business accounts and will apply 50% of the incoming cash to the calculation that determines your income. For some that could be a great statistic; for others, a terrible one. As much as financial advisors and the IRS like you to separate business and personal accounts, it seems to me that you’re more penalized for doing so while pursuing bank statement mortgages because, if you simply moved all of your business cash into a personal account routinely, as it came in, then you could have 100% of your available cash count toward your DTI (for self-employed single-member LLCs or other self-employed Schedule C income). So, you know, you’re damned if you do, damned if you don’t. But, it’s worth researching if you’re having trouble with conventional loans.
Banks are Screwy
This section will be a bit tangential, but shows some of the weirdness that can come into play with mortgages. If you’re self-employed, this is the kind of thing you can expect, and that goes doubly so during the COVID pandemic.
At one point, I tried to purchase an investment property while self-employed. I thought this would be a no-brainer because, for those, you usually get to count 75% of the income that a property generates toward your debt-to-income ratio.
We’d found a property for $440k that was renting out for $4,000 monthly. After a down payment, the loan payment would have been about $2,700 monthly. The 75% figure came out to $3,000.
I still got denied, though, because … well, I’m not 100% sure. I was attempting to leverage my home equity for the down payment (via a cash-out refi) and the underwriter said that since I was proposing a two-loan scenario (a cash-out refinance and an investment property purchase), there was some weird technical possibility that existed during such a transaction wherein (1) I get the cash-out to refinance, but (2) the investment property purchase does not happen for some reason.
In that theoretical case, since I would not be able to pay back the investment loan (which, keep in mind, does not happen!), I could not qualify for that investment loan because there would be no income to support the loan I did not get. If you can make any sense from that whatsoever, I’d be surprised, as even my bank’s mortgage officer could not translate that one into English.
Moreover, when I tried to verify this by looking up actual language on the Fannie Mae web site (where all of the rules are), I was told flat out that mortgage rules exist that are not officially documented. Maybe so… Or maybe that bank simply has it’s own in-house overlays, so to speak, that it applies to lend situations.
These are the kinds of things self-employed people can and do run into! One thing I’ve found that can help to mitigate some of this weirdness is this: Always shop around when you’re self-employed and looking for a loan. Cast the net far and wide because, when one bank deems you not qualified, that doesn’t mean all banks will (even if the first bank cites specific rules or regulations). The sad fact is that the situation I’ve described a few paragraphs above might not have posed an issue at another bank. (It took me way, way longer to learn that lesson than it should have because bank and mortgage reps tend to speak with authority, even when they’re wrong. And they’re wrong a lot!)
Don’t Forget About Reserves
Finally, before you quit a decent-paying corporate W2 job to pursue self-employment. If you think you’re basically close to being ready, don’t forget also that many loans require cash reserves that can add up to six months or even one year of loan payments.
Banks want that money sitting in your bank account as an extra level of assurance that you’ll be able to repay the loan if anything goes wrong. It has to be “seasoned” money, too, which (broadly speaking) means it’s money that’s been in your bank account for at least a few months.
So, for some people ready to make this change, you may want to hold onto that corporate gig and bank six months to a year’s worth of cash (for whatever type of house payment you expect). While this requirement applies to everyone, it can easily be overlooked by someone making a career switch to self-employment and can be a strong case for spending a few months or more pursuing both sides of your money-making so that you can bank the required funds more easily.
Remember: You can’t just “earn twice as much” while freelancing, but you *can* delay quitting and hustle for a few more months in order to pad your savings.
Get Your Home Financing in Order Before Quitting
I’m a huge fan of self-employment (10+ years so far), even if it presents numerous hardships over corporate full-time work. Mainly, it’s the freedom available to you on a day-to-day basis. (I’m able to decide to spend my morning writing this, for example.)
That said, I do think there are many ways in which the business world actively discourages entrepreneurship and self-employment. I mentioned health care atop this piece, as I believe we’d see a surge of entrepreneurs, start-ups, and self-employment if we decoupled corporate jobs and health care.
But beyond those items, there are simply a number of things I wish I’d known prior to making the leap. So, all of the above boils down to one solid piece of advice: Get your home finance and/or mortgage needs solidified before quitting to pursue your self-employment dream.