Difficult For Self-Employed to Qualify For a Mortgage?

January 4, 1999, Revised January 29, 2011

"I am self-employed and want to purchase a house. When I went to a mortgage broker for a loan, he wouldn't give me the time of day! I can't believe that the system doesn't work for people like me."

Lending to the Self-Employed Is Callenging

The system does work for people like you, but not well. The process is more complicated and quite onerous. The broker you went to is probably busy with refinance business, which is often quick and easy, and doesn't want to be bothered with deals that take a lot of time. But there are plenty of others out there that will welcome to work on your case.

Interestingly enough, I have been in at least 6 less-developed countries where it was impossible (as opposed to "more complicated and onerous") for a self-employed person to obtain a mortgage loan from an institutional lender. Their only sources of funding, other than family members, are money-lenders, who charge extortionate rates and may break their legs if they don't pay.

Documenting Income Is the Major Challenge

A major problem with lending to the self-employed is documenting an applicant's income to the lender's satisfaction. Applicants with jobs can provide lenders with pay stubs, and lenders can verify the information by contacting the employer. With self-employed applicants, there are no third parties to verify such information.

Consequently, lenders fall back on income tax returns, which they typically require for 2 years. They feel safe in relying on income tax data because any errors will be in the direction of understating rather than overstating income. Of course, they don't necessarily feel safe that the tax returns given them are authentic rather than concocted for the purpose of defrauding them, so they will require that the applicant authorize them to obtain copies directly from the IRS.

The support it provides to self-employed loan applicants is an unappreciated benefit of our income tax system. It may not be fully appreciated, of course, by applicants who have understated their income. In countries where virtually no one pays income taxes because cheating is endemic, tax returns are useless for qualifying borrowers.

Demonstrating Income Stability Is the Second Challenge

The second problem with lending to the self-employed is determining the stability of reported income. For this purpose, the lender wants to see an income statement for the period since the last tax return, and in some cases a current balance sheet for the business.

The two government-sponsored enterprises, Fannie Mae and Freddie Mac, who purchase enormous numbers of home loans in the secondary market, have developed detailed guidelines for qualifying self-employed borrowers. Lenders looking to sell such loans to the agencies must follow the guidelines. The problem is that implementation can be complicated and time-consuming, especially when the declared income comes from a corporation or a partnership. (If you own 25% or more, you are considered as "self-employed"). The mortgage broker who brushed you off didn't want to take the time, or may not have had anyone available with the skills needed to do it.

The Financial Crisis Made it Tougher For Self-Employed Borrowers

Before the financial crisis, most lenders offered "limited documentation" or "reduced documentation" loans to self-employed applicants who couldn't demonstrate two years of sufficient income from their tax returns. The most widely used were "stated income" documentation, where the borrower stated but was not obliged to verify his income. These loans resulted in widespread abuses (See Sated Income Loans: Lie to Get a Better Rate?), and in the post-crisis market, were no longer available. Full documentation became the rule for all borrowers, including the self-employed. See The Problem in 2010 is Mortgage Underwriting.

The bottom line is that the system does service some self-employed borrowers, but fewer than before the financial crisis. In 2011, there was little prospect that this situation would change in the foreseeable future. 

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