Homebuyers

Self-Employed? Why You May Want to Choose an FHA Loan to Buy a Home

For many people, working for yourself is the dream. When you’re the boss, you control your own destiny…until you apply for a mortgage.

Many self-employed homebuyers may not realize they may be able to qualify for a Federal Housing Administration (FHA) loan with a down payment as low as 3.5% of the sale price of the home.

They may erroneously believe these loans are only for first-time homebuyers. Or they may be worried that if they get one of these loans it will lead to greater IRS scrutiny of their taxes.

Instead, these loans may make it easier for borrowers with business write-offs to qualify for financing in many circumstances, said Sam Alhumdi, a senior loan officer at New American Funding.

“Self-employed clients have a lot of write-offs, and rightfully so,” Alhumdi said. “But as opposed to a Conventional loan, which takes into account your gross income, an FHA loan considers your net [income as well.]”

Why self-employed homebuyers may prefer FHA Loans

FHA loans often offer more flexibility than some other types of mortgages. This may make them more appealing to business owners, entrepreneurs, contractors, gig, and freelance workers.

Some of the perks beyond considering your net income instead of just your gross income include allowing for fluctuating income. An FHA loan allows for a 20% variation in earnings.

Most importantly, if your income falls by 20%, it doesn’t automatically mean your loan application will be denied.

There is also more leniency if your business has transitioned from one entity to another, such as a sole proprietorship becoming a limited liability company (LLC).

Additionally, if you’re going from an employee to self-employed in the same industry, only one year of self-employment history is required as opposed to two years.

This leeway allows those working for themselves a better chance of qualifying for a mortgage.

How self-employed homebuyers may qualify for an FHA loan

FHA self-employed guidelines are a bit more lenient than some other mortgages.

Self-employed homebuyers must:

• Own at least 25% of their businesses
• Have a minimum credit score of 580
• Have a debt-to-income ratio (DTI) no higher than 50%, but 43% or less is considered preferable. (DTI is how much you earn compared to how much debt you owe.)
• Provide at least two years of federal tax returns, including a Schedule C tax form, to verify your income
• Supply a current profit and loss statement so your lender can assess the financial stability and profitability of your business
• Provide business and personal bank statements to prove consistent cash flow
• Present proof of business registration and any relevant licenses
• Cannot have filed for bankruptcy within the last two years
• Have at least a 3.5% down payment. (However, those who put down less than 10% of the purchase price of the home, will pay a mortgage insurance premium for the life of the loan. Those who put down 10% or more, may be able to get the premium removed after 11 years.)

A higher DTI and a lower income or credit score may not mean an instant denial, but you may need a higher down payment, substantial assets, or a solid payment history to get approved.

Power moves to increase your FHA approval odds

Beyond the required paperwork, there are a couple of things that will help improve your odds of being approved for an FHA loan.

“Keep as much of your business assets and transactions separate from your personal as you possibly can,” Alhumdi said. “You can use business assets as a down payment towards a home, but you must make sure that that money won’t affect the day-to-day operations and expenses of the business itself.”

If possible, make any business entity changes two years before you plan to apply for a loan. Although not essential, this helps streamline the application process and eliminates any questions about changing business structures in the middle of the two years of documentation needed.

“When preparing to buy a home, make sure to not take as many write-offs for at least the last tax year, preferably the last two,” said Alhumdi. The write-offs reduce your net income and therefore, your buying power. “Would you rather save money now or live in a [more expensive] home? It's your choice.”

Self-employed homebuyers may want to consider a non-qualified mortgage

For many gig workers, freelancers, and 1099 contractors, income swings of more than 20% are part of the business landscape. If you fall into this camp, a non-qualified mortgage (non-QM loan) might be a better fit.

Instead of two years of tax returns, non-QM loans typically require 12 to 24 months of bank statements, 1099s, or profit and loss statements. Borrowers may also be able to prove asset-based income.

Although this option eliminates write-off scrutiny, it does come with higher requirements for credit scores, generally a minimum 660, and a debt-to-income ratio between 45% to 55%.

Additionally, interest rates on these loans may be a little higher.

Sam Alhumdi NMLS # 32670