Being self-employed can be amazing. You are your own boss and don’t answer to anyone. It’s incredibly liberating and that's a big reason why people leave their jobs to become self-employed. But you obviously lose some of the predictability that comes with having a “normal” job, like a steady income and benefits.
Because you don't have the same level of predictability in your income, getting a mortgage to buy a rental property may be challenging. If you are self employed and a rental property investor (or want to become one), then finding good financing options is critical to growing your rental property portfolio.
Fortunately, there are some great financing options if you are self-employed and looking to invest in real estate. They fall into three categories:
- Traditional Financing
- Direct Lenders
- Creative Financing
We will cover each of these options in detail and go over how to successfully navigate the requirements and avoid the pitfalls associated with each of them. Let’s get into it!
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The information contained in this post is for informational purposes only. It is not a recommendation to buy or invest, and it is not financial, investment, legal, or tax advice. You should seek the advice of a qualified professional before making any investment or other decisions relating to the topics covered by this article.
Table of Contents
Let’s kick off our discussion with traditional financing options. I am talking about mortgages you can get through large banks and other well-known financial institutions.
To lay the groundwork for our discussion, you need to know that most of these lenders don’t keep the mortgages on their books.
Instead, they sell them to Fannie Mae and Freddie Mac. Why does this matter? If these banks want to sell their loans to Fannie and Freddie they must follow underwriting guidelines issued by these government-sponsored organizations.
It’s these guidelines that can create issues for self-employed individuals looking to finance rental properties.
Is it Harder to Get a Mortgage If You Are Self-Employed?
It can be harder to get a mortgage if you are self-employed because of heightened income documentation requirements. Most lenders require proof of income. This is a simple matter for W-2 employees – a copy of your paycheck will do. However, for the self-employed, this can be more challenging.
We'll get into specific income documentation requirements below, but first, let's look at the general mortgage requirements for self-employed individuals.
What Are the Mortgage Requirements if You Are Self Employed
If you are self-employed, you will typically need at least two years of uninterrupted self-employment income and supporting documentation for that income. In addition, you will need to satisfy the other underwriting requirements of the lender, such debt to income ratio, credit scores, reserves and other mortgage qualification criteria.
Source: Rocket Mortgage
Fannie Mae generally requires lenders to obtain a 2 year history of the borrower’s prior earnings.
But if the person has a shorter history of self-employment (12 to 24 months), they may still be considered so long as the borrower’s most recent tax returns show income at the same or greater level in a similar field or business as the current business.
Source: Fannie Mae
Similar requirements are in the Freddie Mac guidelines.
When evaluating whether a self-employed applicant will qualify for a mortgage, lenders will also look to the nature and strength of the business as well as other factors, including the borrower’s debt-to-income ratio, credit score, assets, etc.
According to Rocket Mortgage, you’ll need a lower debt-to-income ratio and higher credit score to qualify for a mortgage if you are self-employed.
How Do You Prove Income If You Are Self-Employed?
If you are self-employed, tax returns are the standard way to prove income. In most cases, you will need to provide at least two years of tax returns showing your self-employment income. Some lenders may also want to see your year-to-date profit and loss statement and balance sheet.
Source: The Mortgage Reports
As we mentioned above, a lender may consider your application even if you have less than two full years of self-employment tax returns, but you will need to demonstrate that you have adequate experience and success in your chosen field (see Fannie guidelines that we covered earlier).
On the flip side, if your self-employment income is not regular or reliable, lenders may not count it.
But there are a lot of businesses that undergo significant but generally predictable fluctuations in income. If that is the case with your self-employment income, you may need to provide more than two years of income documentation to show the lender that these fluctuations are normal and that your business is healthy.
Source: The Mortgage Reports
How Do You Calculate Self-Employment Income For Mortgages?
If you are self-employed, lenders will take your average income over the past two years and divide it by 24 to get your monthly income for mortgage qualification purposes.
So if you made $50,000 in year 1 and $70,000 in year two, you will have made $120,000 over two years. If you divide $120,000 by 24, you get $5,000. That is the monthly income number that lenders will use when evaluating your mortgage application.
Closing Thoughts on Traditional Financing
In general, it looks like you will need two years of documentable and stable self-employed income. If you can meet these income documentation requirements (as well as all of the other requirements we covered above), then traditional financing may make a lot of sense for you.
The rates and terms will probably be more favorable than some of the less conventional financing methods we discuss later on.
But if you just started your self-employment journey, or your income through self-employment is not stable enough to satisfy traditional lenders, there are some great alternative financing options out there.
Direct lenders are one of the alternative financing options you should consider. In fact, their investment property financing programs seem almost perfectly suited to the needs of self-employed people. On that note, let’s dive into it!
If you are having a hard time meeting the qualifications of a traditional lender you can look for “stated income” loans from a direct lender. A direct lender is a lender that does not follow Fannie and Freddie underwriting guidelines because they do not plan on selling the mortgage to those entities.
So they can be far more flexible on who they choose to approve and the standards they use to make that decision.
Stated income loans were very popular before the financial crisis of 2007-2008, but have fallen out of favor since. Still, some lenders continue to offer no-income-verification loans to real estate investors.
For these types of loans, you will likely need a large down payment, high credit score, bank statements, and high income.
Source: American Financing
If you will have a hard time meeting those heightened requirements, another option is to get a loan that is based on the strength of the rental property income. So if the property you are looking to buy has strong cash flow and you meet certain other criteria (such as having adequate reserves, a decent down payment, etc.), you may qualify for financing without having to prove your self-employment income.
The direct lenders offering this type of loan are relying on the property to pay them back rather than you as an individual borrower.
Regardless of the type of loan you get from a direct lender, you should bear in mind that direct lenders use different underwriting standards than standard mortgage lenders.
They may require stricter loan-to-value ratios and, as I just explained, your investment property may need to generate enough cash flow to meet certain debt service coverage ratios. They also typically come with higher interest rates and fees than standard mortgages.
But that’s the price you pay for accessibility.
New Silver is an online direct lender that offers several financing options (with 10 minute conditional approvals). They offer long-term 30 year mortgages for rentals, as well as financing for fix and flips, short term refinancing, and even ground up construction loans.
Check them out below if you are interested.
If neither of the two options we covered sounds appealing to you, you can use “creative” financing strategies that don’t involve the use of banks or financial institutions at all.
Below are some of the most popular options available.
Seller financing is probably the most obvious “creative” financing strategy. It works just like the name suggests: the seller, rather than the bank, finances your purchase of the property.
You can offer a straight-up seller financing deal where you pay the seller a down payment and the seller finances the rest of the purchase price. This will only work if the seller doesn’t need the proceeds from the sale right away.
Seller financing can be a good option when the house has no mortgage on it. That’s because the seller does not need to pay off a mortgage when the property is sold.
If there is an existing mortgage, things get complicated. If the existing mortgage is less than the amount that the seller is willing to finance, then you may need to do a “wraparound mortgage” where the existing mortgage is rolled into a larger loan made by the seller.
But if you do that, a due on sale clause in the bank’s loan agreement with the seller may be triggered, which could make the entire mortgage come due. This will likely blow up the whole deal.
Bear in mind that seller financing deals usually involve shorter-term loans, with a balloon payment at the end. If you can’t find alternate financing when the balloon payment comes due, you will either need to pay the full amount or default on the loan.
But (hopefully) by then, your history of self-employed income will be long enough to get traditional financing for that property.
Buying a Property "Subject To"
Buying a property “subject to” is a real estate investing strategy where you purchase the property “subject to” the existing mortgage. In this strategy, you take over the payments on the existing mortgage in exchange for ownership of the property.
This strategy may even work as a no money down investing strategy if you can convince the seller to let the property go for the price of the existing mortgage. But most sellers may not be that desperate.
Even if you don’t get a no-money-down deal, you should be able to finance a substantial portion of the purchase price by just taking over the existing mortgage.
As with seller financing, if the property is sold with an existing mortgage in place, it could trigger a due on sale clause.
Lease options are another way to invest in a rental property without the need for bank-approved financing.
The typical lease option works like this.
You have found a property that you are interested in buying as a rental but you don’t have the ability to finance it. You talk to the owner to see if they are willing to offer you (i) an option to purchase the property sometime over the next few years along with (ii) a lease to the property.
For example, let’s say the property is worth $100,000 and you offer the owner $3,000 to have the right (but not the obligation) to purchase his property in five years for $100,000.
You also get a lease that allows you to rent out the property at a discounted rate of $1,000 per month for the next five years (let’s assume market rent is $1,100). You would argue that you should get a lower than market rent because you are taking on such a long lease term.
If the owner is having a hard time selling the property the traditional way, they may take the $3,000 now and be happy that they found a 5 year tenant.
You now have a five-year lease and control the property for $3,000 instead of the $20,000 down payment that you would have needed under the traditional buying method.
You then go out and find a tenant that will rent your place for $1,200 and you pocket the difference between your rent and the tenant’s rent each month.
In five years, maybe the property has appreciated to $110,000. In that case, you can exercise your option to buy it for $100,000 (and hopefully by that point, you will be able to buy using traditional financing options or some of the other options we discussed in this article). If you do this, then you have just earned $10,000 through the exercise of your option.
There are more advanced strategies when it comes to lease options, like sandwich lease options, where you offer a “rent to own” program for tenants. In that strategy, you do exactly what I described above, but when you are looking for tenants you offer them a lease option.
So they pay you $4,000 as an option fee to buy the house for $110,000 with a rent of $1200. You pocket the difference all around.
There are a lot of real estate investors who use this strategy with success, but I would tread with caution before moving forward because there are some legal pitfalls that you must navigate when using this strategy.
Use IRA Funds to Purchase Rental Properties
Another way to finance your rental property purchases is to use your IRA funds. This is a little-known strategy, but it is legit. In fact, I have three properties that I purchased using this exact strategy.
Here’s an overview of how it works. You set up a “self-directed” IRA and move your existing IRA funds into that IRA.
You then set up an LLC that that is going to purchase the properties on behalf of your self-directed IRA. I know it sounds complicated, but there are companies that can help set this up for you.
Rocket Dollar offers a ready-made solution to help you do all of this.
What’s better is that you can obtain financing for rental properties and there is no income verification because the properties are bought through your LLC.
If you want to learn more about this innovative strategy for financing your rentals, check out my article on the topic. It goes into a lot of detail on how to get started and goes through the pros and cons of using this option. I also discuss some of the pitfalls you want to avoid when doing this (and pointers on how to do just that).
So there you have it: three great strategies to finance rental properties when you are self-employed.
Hopefully, these additional financing options will help you overcome some of the barriers you may face as a self-employed individual who wants to grow their real estate portfolio.
For more great ideas on how to grow your rental property business, check out my article on how to keep buying rental properties when you run out of money.