Mortgage Lending for Self-Employed Individuals
Canada Mortgage and Housing Corporation (CMHC) has introduced new changes designed to make it easier for self-employed people to get a mortgage. The new changes made public last week, are designed to give lenders further guidance and adaptability as it relates to self-employed borrowers. Implementing these changes, CMHC said several factors could be used to support a lender’s decision in providing a mortgage to someone who’s self-employed. For example, self-employed individuals who have been operating their business for less than two years or have been in the same line of work for less than two years. Those considerations could include the acquiring of an established business; sufficient cash reserves; predictable earnings; previous training and education.
There’s no doubt about it, the burden of income documentation for the self-employed is more complicated than what it is for salaried employees. But the reason for the higher level of documentation is that the process for lenders to calculate self-employment income is more involved. By knowing how mortgage lenders calculate self-employment income, you’ll be in a better position to provide the necessary documentation. As well as having a better understanding of why it’s needed.
How Long Must You Be Self-Employed?
The general rule is that most mortgage lenders look for you to be self-employed for at least 24 months. They will look to document this history through a variety of sources, which can include a combination of the following;
- two years of your T1 General Income Tax returns,
- Notice of Assessment (NOA),
- Statement of Business or Professional Activities (Form T2125),
- Proof of Income Statement,
- Notice to Reader Business Statements for businesses that are incorporated, prepared by a Chartered Accountant,
- Copy of business license or Certificate of Incorporation document.
The reason for the two-year requirement is that lenders understand that income from self-employment is usually less predictable than what it is for salaried borrowers. As such, they will want evidence that you have been in business for at least two years. They will then average your income over that two year period.
As announced earlier this month by CMHC, there are considerations being implemented on October 1st, where CMHC may also accept a shorter time frame. They may consider income if you have been self-employed for less than 24 months.
If they do, you will have to provide your most recent income tax return and other applicable documentation noted above, clearly demonstrating that you have received self-employment income for the entire 12 months covered by the tax return. They will also verify your previous income history, to cover two years of employment. The lender will want to know that you have at least been employed in a similar line of work, even though it’s from a job, and that you have the skills, qualifications, background, education and earnings history to support the self-employment income being used to qualify.
Documentation Requirements for Self-Employed Individuals
You should understand that the documentation requirements for your income will be more extensive than what they would be if you were a salaried employee.
Expect to provide at least your most recent income tax return, and very possibly your returns for the past two years. This may also include business tax returns and notice to reader statements if your business is a partnership, a corporation, or a Limited Liability Corporation (LLC).
Any tax returns required must be signed and complete with all schedules included. Lenders also routinely ask that you provide the corresponding Notice of Assessment (NOA) and/or Proof of Income Statement for each tax filing. This is an effort to prevent the use of fraudulent income tax returns as well as confirm that you’ve paid your taxes in full and there are no outstanding balances owed to Canada Revenue Agency (CRA)
Providing the tax returns themselves usually results in a more generous qualifying income. For example, lenders will add-back non-cash expenses, such as depreciation and amortization, which will reflect a higher income.
Conflicts of the Self-employed When it Comes to Income Taxes
Do you know when you file your income tax return, the basic objective is to minimize your net business income so that you can lower your tax bill? It’s unfortunate, but that’s the exact opposite of what you’ll want to do when you apply for a mortgage. When applying for a loan, you’ll want to maximize your income.
That’s the conflict. You can’t have it both ways – minimize your income for tax purposes, but produce higher numbers for borrowing purposes. What helps with one (taxes), hurts with the other (borrowing). There’s no way to reconcile the two, but as a self-employed person, you need to be aware of this dilemma.
Mortgage lenders will allow you to add back non-cash expenses, like depreciation and amortization, to your income. But any other expenses deducted against your gross income on your tax return(s) will stick.
Calculating Self-Employment Income
In calculating your income from self-employment, lenders use your net business income and not your gross sales or revenues before business expense deductions.
This is an inherent problem for self-employed borrowers. When filing income tax returns, most self-employed people will do their best to lower their tax liability by minimizing their net income. But when applying for a mortgage, they’ll want to maximize their income.
As noted in the last section, lenders will add non-cash expenses like depreciation and amortization to your net income. However, they won’t add back actual expenses, like deductions taken for cellphones, internet, or business travel.
The lender will also average your self-employment income. For example, if your net self-employment income in 2016 was $80,000, and $95,000 for 2017, they will recognize your income to be $87,504 or $7,292 per month
Calculated as follows:
$80,000 (2016) + $95,000 (2017) = $175,000 divided by 24 months = $7,292 per month x 12 = $87,504 per annum.
There can be complications if your income is declining. If your 2016 net income from self-employment was $80,000, and $60,000 for 2017, the lender wouldn’t average your income over 24 months. Instead, they’ll recognize your 2016 income, of $60,000, and average it over just 12 months. That will produce a monthly qualifying income of just $5,000 per month ($60,000 divided by 12). That’s a huge disadvantage when it comes to mortgage qualifying. In fact, the difference in the maximum purchase price using an income of $87,504 vs $60,000 would be approximately $134,000 based on today’s mortgage stress test rules and qualifying rate of 5.34%.
That being said, we know that businesses are cyclical, so an argument can be made to consider these ebbs and flows of a business. Just be prepared that the lender may ask for additional documentation to support the income being presented. If your business is showing a declining pattern of earnings year-over-year, it may result in your application being declined. Especially if the lender determines that the declining trend might lead to your business failing.
It’s so important to show consistent average yearly earnings.
Good or Excellent Credit is a Must
It’s common knowledge the better your credit is, the more likely that you are to be approved for a mortgage. But with self-employed borrowers, credit is just a little bit more important.
The More Cash, the Better
There are few factors that make a self-employed borrower – or any borrower – look more sound than a healthy bank account. Even if you’re making a large down payment on a home, it’s best to have plenty of money left over after closing. That will assure the underwriter that you are financially strong and are less likely to default on your mortgage.
If you’re a self-employed borrower, it’s best not to plan to apply for a mortgage when you are buying a home on a shoestring. Make sure “the vault is full.” It will give underwriting more flexibility if your mortgage application has other weaknesses.
Preparation and Full Cooperation are Your Best Strategies
As a self-employed businessperson, your best strategy in applying for a mortgage is to be prepared for the application process in advance. That means knowing what documentation will be required and having it ready at the time of application.
You should also be prepared to fully cooperate if the lender requests supplemental documentation. When the lender does this, they are asking you to help them justify approving your mortgage. It’s in your best interest to cooperate fully.
The bar is higher for self-employed borrowers when it comes to applying for a mortgage. Being fully prepared for that reality, you increase the chance of getting your mortgage approved.
Using a Mortgage Broker
Because it is difficult to navigate which lender specializes in self-employed mortgages or have more favourable terms for the self-employed, this is the one case where using a mortgage broker has obvious advantages. Mortgage brokers have access to multiple lenders and have a broad knowledge of the mortgage market. Therefore, a broker can connect you to the lender most suited to your personal situation.
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