How To Calculate Self Employed Income For Mortgage

To calculate self-employed income for a mortgage, lenders typically look at your net income from the last two years of tax returns. You’ll need to provide your Schedule C forms, which detail your business income and expenses. For example, if you reported $80,000 in income and $30,000 in expenses over two years, your average annual income would be $25,000, which lenders might consider when assessing your mortgage application.

Understanding Self-Employed Income

Calculating self-employed income for a mortgage isn’t the same as it is for traditional employees. Lenders want to see how much you actually earn after deducting business expenses. This means you’ll need to gather your financial documents, such as tax returns and profit and loss statements, to give them a clear picture of your income.

What Documents Do You Need?

When you’re self-employed, you’ll need specific documents to calculate your income accurately. Here’s what you typically need:

• Tax Returns: Most lenders will ask for your last two years of federal tax returns. This includes all schedules, especially Schedule C, which details your business income and expenses.

• Profit and Loss Statements: If you’re close to the end of your tax year, you might provide a profit and loss statement for the current year to give a more accurate snapshot of your earnings.

• Bank Statements: These help verify your income and can show consistent cash flow.

Calculating Your Average Income

Once you’ve gathered your documents, it’s time to calculate your average income. Here’s a simple way to do it:

1. Total Your Income: Add your net income from both years. For example, if in Year 1 you made $50,000 and in Year 2 you made $70,000, your total income is $120,000.

2. Subtract Your Expenses: Next, look at your total business expenses. If your expenses were $20,000 in Year 1 and $30,000 in Year 2, your total expenses are $50,000.

3. Calculate Net Income: Subtract your total expenses from your total income. In this case: $120,000 - $50,000 = $70,000.

4. Average It Out: Divide by the number of years. In this case, $70,000 / 2 = $35,000. This would be your average annual income for mortgage lenders.

Real-World Example: Sarah the Teacher

Let’s take a look at a specific example. Sarah is a 35-year-old teacher in Denver who also has a side business making custom furniture. Over the last two years, her tax returns show the following:

• Year 1:
  • Income: $50,000
  • Expenses: $20,000
• Year 2:
  • Income: $60,000
  • Expenses: $25,000

To calculate her average income:

1. Total Income: $50,000 + $60,000 = $110,000
2. Total Expenses: $20,000 + $25,000 = $45,000
3. Net Income: $110,000 - $45,000 = $65,000
4. Average Annual Income: $65,000 / 2 = $32,500

Sarah can report an average annual income of $32,500 to lenders when applying for her mortgage.

Considering Your Debt-to-Income Ratio

Lenders also look at your debt-to-income (DTI) ratio, which compares your monthly debt payments to your gross monthly income. For self-employed individuals, this can be a bit tricky since income can fluctuate.

How to Calculate DTI

Here’s how to calculate your DTI:

1. Add Up Monthly Debt Payments: Include all monthly obligations like credit card payments, car loans, and any other debts. Let’s say Sarah has $1,200 in monthly debt payments.

2. Calculate Monthly Income: Divide your annual income by 12. For Sarah, it would be $32,500 / 12 = $2,708.33.

3. Calculate DTI Ratio: Use the formula: (Total Monthly Debt Payments / Gross Monthly Income) x 100. Sarah’s DTI would be ($1,200 / $2,708.33) x 100 ≈ 44.4%.

Most lenders prefer a DTI below 43%, but it can vary based on the lender and other factors.

Adjustments for Fluctuating Income

Self-employed income can vary greatly from year to year. If you show a significant increase or decrease in income, lenders may want to see explanations or additional documentation.

Average Income Over Multiple Years

If your income fluctuates, you might average over three years instead of two. This can help smooth out any significant highs or lows. For example, if Sarah’s income was $40,000 in Year 1, $50,000 in Year 2, and $60,000 in Year 3:

1. Total Income: $40,000 + $50,000 + $60,000 = $150,000
2. Average Income: $150,000 / 3 = $50,000

This can look more favorable to lenders.

The Importance of Maintaining Good Records

Keeping detailed financial records is crucial for self-employed individuals. Good record-keeping not only helps you calculate your income accurately but also makes the mortgage application process smoother.

Tips for Efficient Record Keeping

1. Use Accounting Software: Programs like QuickBooks or FreshBooks can help you track income and expenses easily.

2. Keep Receipts: Save all business-related receipts to substantiate your expenses.

3. Regularly Update Financial Statements: Make it a habit to update your profit and loss statement monthly or quarterly.

FAQs

1. How do lenders verify self-employed income?

Lenders typically request tax returns, profit and loss statements, and bank statements to verify self-employed income. They’ll assess your net income and any fluctuations over the past two years.

2. What if I’ve just started my business?

If you’ve been in business for less than two years, lenders might require you to provide additional documentation, such as a business license or a letter from a CPA.

3. Can I use my gross income instead of net income?

Most lenders prefer net income since it reflects your actual earnings after expenses. Using gross income might not provide a true picture of your financial situation.

4. What if my income is inconsistent?

If your income varies widely, lenders may average your income over multiple years or consider using a “year-to-date” profit and loss statement to assess your current earnings.

5. What’s the maximum DTI ratio allowed for self-employed borrowers?

While most lenders prefer a DTI ratio below 43%, some may allow higher ratios based on compensating factors, like a strong credit score or significant cash reserves.

Conclusion

Calculating self-employed income for a mortgage can seem daunting, but with the right documentation and a clear understanding of your finances, you can present a strong application. Keep your records organized, and don’t hesitate to seek help from a financial advisor or mortgage professional if needed.

If you’re ready to apply, start gathering your tax returns and financial statements now. This’ll put you on the right track toward homeownership!