The home buying process has evolved over the years, but one thing will never change: Your income will be one of the main factors mortgage lenders will look at when determining your borrowing power.

And if you're one of the 9.6 million self-employed individuals in the United States, you might wonder whether your lender will use your net or gross income. Because let's be honest—this can make a huge difference in the amount you qualify for.

While there's a lot of conflicting information surrounding this topic, we're here to help clarify things and explain how mortgage lenders determine self-employment income.

TLDR Key Takeaways

• Depending on your lender's guidelines, they might look at your gross or net income when determining if you are eligible for a mortgage.  
• There are a variety of available programs that use your gross income instead of the taxable income listed on a business tax return.
• While income is a large part of determining your borrowing power, you'll still need to meet additional requirements to qualify for a loan.

Do Mortgage Lenders Use Gross or Net Income for Self-Employed?

While there are several programs out there that allow lenders to use your gross income to qualify you for a mortgage, generally speaking, most lenders will use your net income (or income after business expenses are deducted).

Why?

Because most traditional banks are held to underwriting guidelines that require them to use the taxable (net) income listed on a business tax return, it's viewed as a more accurate reflection of earnings since it shows your income after expenses are paid. 

However, that's not necessarily the case. For self-employed borrowers who like to take advantage of write-offs or those with high expenses, this can be a big problem because it lowers their overall borrowing capacity. 

However, depending on the lender's specific guidelines for self-employed borrowers, they can look at both gross and net income to determine your eligibility.

When Would A Lender Use Gross and Net Business Income?

The answer to this question largely depends on the lender's assessment of the borrower's ability to repay the loan. 

There are a few different scenarios in which a mortgage lender may use both gross and net income to qualify a borrower, such as:

• The borrower is self-employed (1099, subcontractor, freelancer, etc.)
• The borrower has multiple sources of income (rental income, investment income, child support, etc.)
• The borrower has a high amount of deductions on their taxes

In each case, lenders will analyze the borrower's income information to determine if you're suitable for the loan and how likely you'll pay back what's owed. 

By using gross and net income, the lender can get a more accurate picture of the borrower's financial situation and make a more informed decision about whether or not to approve the loan.

If you are unsure of which income figure your lender will use, it is best to ask in advance so that you can be prepared with the necessary documentation.

How is Self-Employed Income Calculated for a Mortgage?

Self-employed income can be a bit more tricky to calculate for a mortgage than traditional employment income since there's often more variability in your earnings.

Lenders will typically start out by calculating your average monthly income using a two-part formula. It looks like this:

Part 1‍

(Year 1 Earnings +  Year 2 Earnings) / 2 = Average Annual Income

Part 2

Average Annual Income / 12 = Average Monthly Income 

Let's break that down. For example, in your first year, you made $75,000, and in the second year, you made $100,000. They would add those two together and divide them by 2, like so:

($75,000 + $100,000) / 2 = $87,500

From there, they would divide that number by 12 to get your average monthly income, like this:

$87,500 / 12 = $7,292

Once they have this number, they'll factor in the debt-to-income ratio (DTI) and make sure that you have enough money left over to cover your mortgage payments. They use another two-part formula like this:

Part 1

(Average Monthly Income x DTI) = Maximum Allowable Debt per Month

Part 2

Debt per Month - Existing Expenses = Maximum Mortgage Payment

Let's continue with that example. We know that you pull in, on average, $7,292 per month. We also know that most lenders prefer a DTI of 36% or less, so let's use that at the cap for demonstration purposes.

$7,292 x 36% = $2,625

That means $2,625 is the maximum amount of debt you can have per month, including your mortgage. So if you pay out $700 in monthly expenses, the maximum mortgage payment you can qualify for would be $1,925. 

Now, it's important to note a few things here:

1. Some lenders allow a DTI of up to 52%; however, many put a cap at 43%.
2. If you have high monthly expenses, it lowers your overall mortgage payment.
3. Depending on your lender and program requirements, they will look at either your average net or gross income. This can be a HUGE difference in this calculation. 

What Else May You Need to Qualify for a Mortgage as a Self-Employed Individual?

On top of your income, there are a few additional things you may need to qualify for a mortgage, such as: 

• Bank Statements: Rather than relying on tax returns to prove your income, lenders will review 12 to 24 months' worth of bank statements to determine your gross income.
• CPA Letter: This letter from your accountant must state the percentage of the business you own, that your business is in good standing, and that you have been self-employed for at least two years. 
• Business Questionnaire Form: This is a set of targeted questions to help lenders understand details about the prospective homebuyer, the property they're interested in, and their eligibility for repaying the loan.
• Cash Reserves: Lenders typically require a minimum of six months of cash reserves for borrowers. 
• Personal Asset Statement: Lenders may require a personal financial statement covering at least two months' worth of documentation for the business's assets and liabilities.
• Driver's license: This will be used to confirm your identity.

Get the Guidance Your Need with Modern Day Lending

We know self-employed borrowers often have unique financial situations that traditional big banks won't accommodate, which is why we'll work closely with you to understand your needs and find the right loan for you.

Self-employed mortgages can be a little more complicated to qualify for than traditional mortgages, but that doesn't mean they're impossible to get. 

We have a deep understanding of underwriting guidelines that allow us to tap into a wide range of programs, so we're sure to find one that meets your specific requirements.

If you have any questions or want to learn more about our unique programs, reach out to a member of our team. We're here to help!