When a potential borrower applies for a home loan, one of the most crucial factors the lender will consider is their taxable income to ensure they can afford the monthly mortgage repayments. A self-employed applicant, however, will be less straightforward, as their monthly income isn’t as easy to prove or calculate.
Freelancers, small business owners, and other independent contractors may not have a regular payslip, so lenders must determine their income by profit-and-loss statements, and tax returns.
Once lenders have established that your income is sufficient and are satisfied with your tax returns, they will follow the traditional borrowing capacity calculations to work out the details of your home loans.
Here’s how they calculate a self-employed mortgage.
Who Qualifies for a Self-Employed Home Loan Mortgage?
When applying for a home loan, a self-employed person is anyone receiving income from their owner business and revenue received is paid into their business.
Self-employed people are:
- Sole proprietors
- Partners with a minimum of 25% ownership.
- Business owners
- Those receiving over 25% of your income from bonuses or commission.
- Those paying self-employment tax.
Borrowers must prove that they have been operating in a self-employed capacity for a minimum of two years to meet most lenders’ eligibility criteria for a self-employed home loan application. You can do this by providing a confirmation of business registeration.
How Do Lenders Calculate the Income of Self-Employed Borrowers?
Lenders typically look at borrowers’ past tax returns in an effort to forecast how secure their business is likely to be in the future, and ascertain whether they will be able to make both principal and interest repayments. They seldom approve home loans if a potential borrower’s income has increased or decreased significantly over the past two years, which shows instability within their operations.
Lenders may consider any of the following:
- The smallest income figures over the past two years.
- The latest income as per the borrower’s tax return.
- The average of two years’ income.
- 120% of the lowest year’s income.
- A letter from the borrower’s accountant and six months’ payslips.
- A tax portal printout from the Australian Taxation Office (ATO).
- Business Activity Statements (BAS).
Lenders will also assess current income according to entrepreneurial skills, experience in the relevant industry, and the industry’s risk profile.
Calculating Your Borrowing Power
Once a home loan specialist is satisfied that you have proof of a stable income, has calculated the income amount, and conducted a tax assessment, calculating your mortgage will be the same as a standard home loan process.
Here’s what can impact the calculations of borrowing power:
Part of the home loan application process is considering the potential borrower’s expenses and commitments.
- Existing Mortgage: This is at its true loan balance and repayment amount, or a lender may use a higher assessment rate by adding on a few per cent to account for future interest rate increases.
- Credit Cards: Lenders typically consider credit cards using their fully drawn amount, with 2-3% of the credit limit as a monthly repayment.
- Personal Loans: Lenders mostly use the true personal loan repayment amounts.
- Rental expenses: If the borrower lives with their parents rent-free, some lenders factor in an additional $150 per week as a rental expense to cover the possibility of them having to move out.
When determining a borrower’s potential available home loan amount, lenders consider the highest between:
- the family’s estimated living expenses
- the predicted minimum expenses of a family of the same size
Most lenders use the Household Expenditure Method (HEM). This calculates a certain amount for the first adult and child. Each adult or child will have a smaller amount than the sibling before them.
When calculating the borrower’s income for a self-employed home loan, lenders set the home loan repayments using an interest rate higher than what it will be upon approval or add an expense that doesn’t exist to act as a buffer.
Once lenders deduct the expenses and the buffer from the potential borrower’s gross monthly income, it will result in a surplus or a shortfall. Unfortunately, a surplus alone isn’t enough for a lender to approve a self-employed home loan. A lender’s assessment also takes into account factors such as:
- credit history
- credit score
- loan to value ratio (LVR)
- genuine savings
Have You Considered a Low-Doc Home Loan?
People wanting to take out self-employed home loans without standard PAYG payslips or the required tax returns and financial statements can still be approved; they should just consider applying for a low-doc home loan.
Low-doc home loans have been designed for the increasing number of people who earn a sufficient income for a home loan approval but don’t have the necessary paperwork to prove it.
Not all standard lenders offer the option of a low-doc loan, so self-employed people can benefit from using a specialist mortgage broker to help them find the lender that offers the home loan appropriate for their financial situation.
Self-employed individuals can apply for home loans from any financial institution with an Australia Credit Licence, and their mortgage is calculated the same as anyone else’s.
The difference is that lenders require different and more in-depth paperwork to prove their income is sufficient, even though it’s not regular.
Once this is confirmed, lenders will continue the standard process of home loan calculators by considering:
- Existing commitments & loan amounts
- Living expenses
- Credit history, credit score, LVR, and genuine savings
Self-employed borrowers that don’t have the required documentation can consider low-doc home loans.
A home loan specialist, such as a mortgage broker, can assist anyone through the process of becoming a homeowner, offering professional advice on how much to borrow based on your current financial situation, whether to opt for a fixed rate period or explore variable rate home loans, and much more.
If you are eager to buy property but aren’t certain if you meet the lending criteria, contact The Mortgage Agency today and we can discuss the different home loan options available to you.
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.