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Getting a Loan While Self-Employed

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By Sallie Hyman

Qualifying for personal loans when you are self-employed can be very difficult, especially in today’s economic climate. Most people are looking for mortgages, either a first-time mortgage or refinancing a current mortgage. Many also seek car loans.

It was not that long ago that banks would throw money at you as you walked in the door. That has changed dramatically in the wake of the subprime mortgage scandal.

Prior to the housing crisis two popular loan options included no documentation and stated income/stated asset (low documentation) loans. These riskier loans are not offered by many lending institutions today. If they are available, the interest rates are usually quite high, making them a less appealing option. Most banks will ask for verification of stated income by requesting your Schedule C forms from at least the last two years.

Preparing for the Process

The self-employed are now faced with trying to qualify for a traditional, fully documented loan. One of the greatest hurdles facing them when trying to get that loan is the paperwork. Traditional employees can verify income with a couple of years’ worth of W-2s. It requires much more diligent work on the part of the self-employed to prove their income. It is imperative to keep good records. Make sure that all large payments received are properly documented so that they will be recognized as income. Try to keep business and personal bank accounts separate. Keep copies of all tax returns so they are readily accessible.

At least two years of tax returns will be required. Some lenders will ask for a Form 4506 or 8821. Form 4506 is used to request a copy of your complete tax return directly from the IRS, thus preventing you from submitting falsified returns to the mortgage company, and costs $39 per return. But you may be able to request Form 4506-T (limited return) for free.

Form 8821 authorizes your lender to go to any IRS office and examine the forms you designate for the years you specify. This service is free. Banks may also ask for a copy of your business license to prove that the business actually exists. Other documents often requested include a signed statement from an accountant, profit and loss statements and balance sheets.

There are some things that you can do to make yourself a more attractive candidate for lenders if you are seeking a traditional loan. Experts recommend that you:

1.  Know your credit score and make sure it is high. Correct any errors and do what is necessary to maximize it.

2.  Offer a large down payment. This will show that you have
a vested interest in the home or vehicle and it will also help to lower the loan amount.

3.  Have significant cash reserves. Maintain an emergency fund. This will show lenders that you can continue to make payments even if business drops off.

4.  Pay off all other debt. Pay off credit cards, car loans, and any other debt you have. This will free up available money for mortgage payments.

5.  Be in business at least two years. Most banks want to see that your business has been established for at least two years. With a failure rate of over 40 percent for small businesses, banks want to see some longevity.

Even if you have all of the documentation, the banks may still be reluctant to lend due to what appears to be a low income. Most businesses will write off as many business expenses as legally possible to reduce taxable income on tax returns. This is great for helping you not have to pay much in taxes, but can be a negative when it comes time to borrow money. Mortgage eligibility is based on net income, meaning all those business deductions actually count against the borrower.

NASE Member Dudley Dix, owner of Dix Design, in Virginia Beach, Va., found this out the hard way when trying to refinance his home. Dix started working with the bank that held his mortgage. Because his company was set up as an S-corporation, part of his salary was recorded as a distribution, and the bank would not include this as income.

“Mine is a very small business that employs only me and my wife. All of the income of the business minus expenses becomes my income. In excluding the distributions portion they halved my income and disqualified us from refinancing. They said that we could not afford to pay the new mortgage repayments, even though they were to be lower than what we were paying to them at the time and on which we had never missed a payment. They were effectively forcing us to pay higher interest rates.”

After two years of trying to work with his bank, Dix was finally able to refinance with another institution.

One exception is depreciation on business-related purchases, which can be added back into the borrower’s net income to help them qualify. For example, if you write off depreciation on a car that was purchased for the business, you can write off some depreciation, but because it is a paper loss, not a real cash loss, you can add that depreciation back into your net income. That will help to increase your overall net income.

This brings up a very important point to discuss with your tax professional if you know that you will be looking to borrow money in the near future. It may be worthwhile to not take every possible business deduction on your taxes in order to show a larger net income. You will have to pay more taxes, but it will allow you to show more income to lenders.

If you need to borrow the money now and can’t wait two or three years to show greater income, then you can consider amending past tax returns. You will have to pay taxes on the amended return, but again, it will help to show a greater net income. An accounting professional can advise you on how to do this correctly. But note that the IRS has a three-year statute of limitations on amending returns.

Finding the Right Lender for You

Choosing the right lending institution will make a big difference for the self-employed. “Big-box” banks usually have a neat little computerized mortgage loan program that requires all the boxes to be checked. That may be difficult for someone who is self-employed since they do not have a W-2 to show or may have to produce extra documentation. It is likely that you will be turned down by these big banks because they are either not willing or not set up to deal with non-traditional borrowers.

It may behoove a self-employed borrower to look into smaller banks and lending institutions. Local banks with lenders that understand the area and know their customers may be a more willing option. They do not have to play by the strict rules of a large corporate bank and may be more flexible.

Credit unions are also an alternative to the big banks. They are growing in popularity as people are seeking options. These non-profit cooperatives have members who are their clients. They are still highly regulated to ensure the safety of your money, but since they are independently run, they can offer lower interest rates and fees and are able to work more with non-traditional borrowers.

NASE Member and author Skip Press, of Burbank, Calif., turned to his local credit union a few years back when he needed to refinance his vehicle. “My local credit union was much more understanding than banks. I try to ‘keep local’ as much as possible,” says Press. Many credit unions are now offering mortgages in addition to personal loans to fill the void for those who are finding it difficult dealing with big banks.

If none of these options are viable for you, you can consider seeking a co-borrower who is a W-2 employee or finding someone who is willing to co-sign a loan for you.

Finding the right loan can take more time and effort when you are self-employed.
Be prepared to meet with several lenders to get the best rate you can, have all of
your documentation organized and available, and have the patience and persistence to get the job done. 


Sallie Hyman writes on small-business issues and owns and operates her own small businessin Purcellville, Va.

 

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