If you’re part of the gig economy, you’re not alone. According to a recent report from the McKinsey Global Institute, nearly a third of Americans earn at least some of their income as freelancers. The big rise in short-term contract income comes at the same time as a slight decline in the percentage of Americans who are fully self-employed – down from 12 percent in 1994 to just over 10% in 2015.
But whether you supplement your income with freelance work, or you own your own small business, odds are you’ll have a harder time qualifying for a mortgage loan. However, a “harder time” doesn’t necessarily mean a higher probability of failure. It just means there will be closer scrutiny of your earnings and more paperwork before closing. Here’s how you can make the process go smoothly and increase your chances of success.
Improving Your Credit Score
Mortgage loan approval depends on three main factors: credit score, debt-to-income ratio (DTI), and employment history. If you’re self-employed, verifying employment history is going to be the hard part. Thus, you should make the road leading there as smooth as possible.
Improving your credit score to reach “excellent” range (740 or better) shows lenders that you can handle debt responsibly, improving the likelihood of approval. A high credit score will also help you to qualify for a loan with the best interest rate.
Improving your credit score in the short term isn’t easy to do. One quick fix is to check your report and make sure that there are no mistakes. This is especially important for divorced individuals. Even though you’ve removed your name from a credit card your ex uses, that card could still be on your report, affecting your credit score.
Lower Your Back-End Debt-to-Income Ratio
Lenders typically look at DTI in two ways:
• Front-End DTI measures your combined mortgage, insurance, and tax payment each month against your total income. Most lenders want to see these payments as no more than 28 percent of the total.
• Back-End DTI looks at your total monthly debt payments – housing costs plus credit card payments, car payments, student loans, and alimony – in relation to your income. Here, the magic figure is 30%, though some lenders will go as high as 40%.
There’s not much you can do to improve your front-end DTI, at least not in the short term. One option is to find a property that costs less – not always possible in your community.
But you can improve the back-end DTI in several other ways:
• Trade in your car in for a less expensive model to lower (or ideally, eliminate) your car payment.
• Ask family members for a loan to pay off some revolving debt. Remember – reducing the debt won’t help, as the monthly payments will remain the same.
• Pay your credit cards in full before the bank runs your credit.
Be aware that even if you pay your credit cards in full each month when the cycle ends, your lender will look at how much debt is on your card when they order the credit report, then estimate a payment based on that amount. That estimated payment affects your back-end DTI. The only way around this is to clear your balances right before the check.
Understand How Lenders Determine Your Monthly Income
As a freelancer or a small business owner, you already know that there’s no such thing as regular income. Lenders know that, too, and they aren’t going to penalize you just because you don’t have monthly pay stubs.
Instead, they will ask you to fill out IRS Form 4506-T, which authorizes the government to allow lenders to view your tax records. The bank will look at your adjusted gross income from the last two years on record and divide that figure by 24. This is what lenders use to calculate your monthly income.
Other documents your lender may ask for include bank statements and proof of on-time rent payments for the last 12 months. Be punctual when turning in documentation to your lender. Being prompt and proactive will go a long way in showing responsibility which will lessen your risk in the eyes of your lender.
Is There Wiggle Room?
The thing that makes lenders most reluctant to finance self-employed mortgages is a concern that the bottom will drop out of their income. Picking up a part-time job with an employer, especially one who offers benefits, is a good idea if your business isn’t well established.
Another option is to make a large down payment on the house. That will improve your DTI and mitigate the lender’s risk.
About Peak Finance Company
Peak Finance Company is a mortgage banker and broker that specializes in solutions-based lending, currently operating in California, Oregon, and Georgia. The company prides itself on offering a personalized and creative approach to the mortgage-lending process, one that makes it possible to offer loans to self-employed individuals at the most competitive rates. Follow Peak Finance Company on Facebook for updates and industry news.