Do-It-Yourself Mortgages

By age 30, Seattle-based freelance writer Jane Hodges was ready to buy a home. But because she was self-employed, she learned that she needed at least two full years of self-employment before lenders would consider her for a mortgage.

Writer Jane Hodges took a salaried job to help her qualify for a loan.

So she turned what was supposed to be a six-month contract at the Seattle Times into a full-time job, leaving her freelance life behind. "I knew if I stayed, I could qualify for a mortgage," Hodges says. It worked—she bought her house for $225,000 in 2004. Then five months later, she quit her job and became a freelancer again.

As Hodges discovered, the self-employed face a different set of rules for getting a mortgage compared with their cubicle-dwelling peers. Entrepreneurs and small-business owners have a tougher time proving what they make, and they often subtract business costs from their income for tax purposes. Revenues frequently vary greatly from month to month. Lenders also worry about the continued success of that pineapple-themed restaurant or boutique maternity store.

But that doesn't mean the Hodges route—taking a full-time job—is the only option. Lenders offer two main choices to self-employed borrowers: stated-income loans and regular loans with full documentation of income. Stated-income loans are based on how much borrowers say their income is, instead of how much they can prove it is. That means there's no need to provide two years of completed tax forms. Because it's a riskier loan from the lender's perspective—people can lie about their stated income, or it can fall off suddenly—the interest rate is usually half a percentage point or so higher. But a high credit score or large down payment can help reduce that rate, says Luke Currier, a mortgage consultant and founding member of the National Association of Responsible Loan Officers.

This year's subprime meltdown has made it more difficult to find stated-income loans. "Credit markets are only interested in the least risky stuff," says banking consulting Bert Ely. As a result, he says, the availability of stated-income loans is "extremely tight." If consumers looking to borrow do get offered a stated-income loan, he suggests examining the lender carefully to make sure it is a legitimate operation.

In the second quarter of 2007, 62 percent of mortgages not backed by Freddie Mac or Fannie Mae were based on a low level of documentation or none at all, according to First American LoanPerformance, which measures risk in the market. In the third quarter, the share dropped to 60 percent. (Freddie Mac and Fannie Mae securitize low-documentation loans only on a limited basis.)

That percentage will very likely continue to decline as lenders work to reduce their risk levels, says Damien Weldon, a vice president at First American LoanPerformance. "The innovations, particularly in the subprime market, that brought a whole host of borrowers into the mortgage market, facilitated in part by low- and no-doc loans, [do] appear to be at an end," he says.

Get organized. The other option for the self-employed—a loan with full documentation of income—usually requires at least one year's worth of tax returns, and sometimes two, says Allison Vail, spokeswoman for LendingTree.com. But she doesn't recommend sitting around and waiting. Vail says future borrowers should check their credit score, which will affect their interest rate, and, if necessary, improve it by paying down debt and making on-time monthly payments. Keeping detailed financial records will also help when it's time to work with a lender.

She also recommends—for both the self-employed and the traditionally employed—learning about the various mortgage-related fees ahead of time. Some, such as the appraisal fee, administrative fee, and title insurance, are negotiable. "If you don't mind doing the legwork, sometimes you can find some good savings there," Vail says.

Some costs, on the other hand, such as hazard insurance to cover property damage from wind, fire, and storms, are unavoidable, even though the home buyer may never have heard of them before. Aditya Bhasin, head of marketing for consumer real estate at Bank of America, says, "A lender won't quote that upfront, but that is a legitimate insurance fee you have to pay." And city, state, and local taxes are usually unavoidable, too, he adds.

Many people, says Bhasin, end up confused at the closing table when fees pop up that were not advertised in advance. Buyers can lower their chances of last-minute sticker shock by carefully reviewing the "good faith estimate" of closing costs as well as something known as a HUD-1 statement, both of which are provided by the lender. Those two documents cover all the fee details, including those not broadcast in radio or television advertisements of teaser rates.

Because the self-employed often see their incomes fluctuate from month to month, saving a reserve of cash ahead of time to help with the mortgage payment in those leaner months can provide a safety cushion. Kerith Henderson, owner of a small public-relations firm in Los Angeles and a homeowner with her self-employed composer husband, says, "It always comes down to, 'How are we going to pay? Should we have a garage sale?'" Somehow, she says, "the money always comes in."