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At first glance, securing a mortgage when you are self-employed may seem a little difficult. There is the historic conundrum, minimising your profit to reduce your tax burden which will inadvertently, in theory, reduce the level of mortgage funding available. There are also many other aspects to take into consideration such as different types of income, shareholdings, dividends, foreign companies and the right time to apply for a mortgage. We will now take a look at these subjects and more in detail below.
There are various routes to self-employment and different structures which can be put in place. It will depend upon the type of business, size of business, income and long-term aspirations, but a sole trader is not the only type of self-employed status that lenders will recognise. We will therefore take a look at some of the more common types of self-employment and the different structures.
A sole trader is the simplest form of self-employment where you and your business are legally defined as one and the same. This means that income from self-employment and income from elsewhere will be consolidated into one tax return. In order to operate as a sole trader you need to register online with HMRC to make them aware of your business and prepare them for receipt of your tax return each year.
The most common setup for a limited company is for the individual to be a director and an employee. They will be entitled to a share of the company’s profits via dividends as well as a salaried income. This is where it can become tricky with regards to the affordability factor for lending such as mortgages. It is possible to pay a minimal salary, topped up by dividend payments, to reduce tax liabilities. However, mortgage lenders may deem the salary to be the constant form of income and the figure used in the affordability calculations. In reality, there is every chance that the individual could adjust the balance between salaried income and dividends but incur greater tax payments.
There are some subtle differences between a sole trader, limited companies and general/limited liability partnerships. General/limited liability partnerships are created under the Limited Partnerships Act 1907 which allows general partners to work alongside limited partners in a business association. The general partners effectively control the day-to-day running of the business and are liable for the partnership’s debts and obligations. However, a limited partnership member is akin to a passive investor with their liability limited to the amount invested and/or any personal guarantees given.
Even though a contractor is still a form of self-employment this type of employment has its own specific affordability criteria – based upon the value of the contract(s). The more common way to set up a contracting business is to create a limited company which will invoice customers and receive funds. The individual is in effect an employee of the limited business and will either own a part share or all of the business depending upon the structure. Income can be paid via the traditional salaried route and/or dividend payments out of profits. As the business is limited this will mitigate the individual’s liability to funds invested and/or personal guarantees given.
Contractors have their own special calculation with some lenders – so rather than their self-employed figures being used, they will take the value of the contract. The ‘value’ depends on how the lenders calculate it, but the general rule of thumb is daily rate x 5 x 46 = annual salary. The client needs to have x amount of time left on the contract, and x amount of time contracting (although if they have gone from the same line of work we can get lenders to consider this as one).
There are many different types of income which can be drawn from various forms of self-employment. These include anything from the traditional salary (through the PAYE system) to bonuses, dividends, director’s loans and drawings. We will now take a look at these in more detail giving you a broader understanding of how they are treated.
When looking to arrange any form of finance the first thing a lender will look at is your salary. This relates to employment through some kind of partnership or limited company in which you likely have a majority shareholding or perhaps own the company outright. This is paid through the PAYE system and taxed at source so that any tax liability is paid on an ongoing basis.
Bonus income is certainly a bone of contention amongst mortgage providers and it will depend upon the type of lender you approach us to how it might be acknowledged. There are many businesses where a bonus is part of the overall package, perhaps paid annually, but it may not be a constant. Therefore, where a lender is likely to acknowledge bonus income when calculating the affordability factor for a mortgage, they often take an average of over two or three years. Some lenders such as private banks may be little more flexible and not only look back at historic payments but also forward at projected future income.
As dividend income is paid out of company profits it is susceptible to the underlying profits of the company in question. Dividend income received by shareholders will already have been taxed at the relevant corporation tax level but higher rate taxpayers would need to make additional payments. Many self-employed people use company dividends as an efficient way of topping up their salaried income because it avoids issues such as national insurance payments. However, on the flipside of the coin, only specialist lenders will appreciate dividend income when calculating affordability for borrowings.
Many directors will have a director’s loan account with the company from which they can draw and repay money throughout the year. Any withdrawals are free of tax at the point of receipt but payable with 9 months and 1 day after the company’s year-end otherwise interest charges will be incurred. The most common use of director loan accounts is to top-up income throughout the year, declaring a dividend at the end of the year and then using the dividend income to repay the directors loan.
There is a specific distinction between salaries and drawings with employee salaries paid through a company’s PAYE system. Many self-employed people might be surprised to learn that drawings are not included as an expense in a profit and loss balance sheet. Classified as the business owners “personal income” it is only after the year-end when the profit and loss account has been completed that you are able to confirm the maximum drawings available. There will be occasions where self-employed people have taken out more drawings than were available, possibly leaving the business short to cover tax and other year-end payments.
Bona fides expenses as a self-employed person would basically go towards paying the cost of services associated with your business. Therefore, the net benefit is zero because you will generally have paid out the money before you are reimbursed. As a consequence, expenses income whether a sole trade or employed by your own limited company is irrelevant when it comes to the affordability calculation.
As the vast majority of employee benefits go towards a particular expense such as the cost of running a vehicle for business use, there is not generally any net benefit to the employee. Indeed, many employee benefits are now taxed as part of your employment package so irrelevant in their own right for the mortgage affordability calculation.
While there is no doubt that self-employment is increasing in the UK (see the graph below) the situation is slightly different when it comes to self-employed mortgages. Figures show that self-employed mortgages in 2006 made up around 17% of all mortgages in the UK. After a significant fall in light of the US mortgage crisis of 2008, the figure has gradually improved but even now stands at just 11%. The number of actual self-employment mortgage approvals is now around 30% of that in 2006.
Prior to 2008 self-employed people looking for mortgage finance were able to “self-certify” their income. This in effect meant that someone who was self-employed could “confirm” their own income without having to prove the actual figures. Looking back, this was a potential recipe for disaster as many self-employed people massaged their figures and pushed their finances to the limit. The property market/worldwide economy crash of 2008 saw a number of self-employed people struggling to cover their mortgages with their “real” incomes coming to the fore. As a consequence, self-certified mortgages were banned and the self-employment mortgage market has been rebuilding ever since.
The latest median income figures for salaried employed and self-employed individuals also make for interesting reading. There is some scope for these figures to be massaged on the downside for self-employed men and women, to reduce their tax liabilities. However, when looking for mortgage finance there is a need to maximise income and minimise expenses. The exact opposite of what many self-employed people are used to doing!
One interesting trend in the self-employment market is the significant increase in one-person businesses or partnerships (with no employees) compared to self-employed individuals who take on employees. For many people, the ever-growing costs of taking on employees such as sick pay, holiday pay, pensions, training, etc are just not worth it. This is a trend likely to continue as the tax burden for employees continues to grow with the ever-increasing minimum wage and living wage.
This next graph casts an interesting light on regional levels of self-employment and changes between 2001 and 2016. Despite the challenging economic environment, all areas of the UK have seen an increase in self-employment numbers. This is probably down to a mixture of natural entrepreneurism in the UK and areas of difficulty in the UK employment market. The Internet has also created an interesting information portal for those looking to go self-employed offering a step-by-step guide to taxation, contracts, finding new business and planning for the future.
It is fair to say that Brexit has reduced activity and to a certain degree confidence in the UK economy in the short term. This in turn will have impacted self-employment numbers but the ability to maintain a low-cost base by working from home, utilising the latest technology and minimise expenses will support the sector going forward.
In summary, the UK self-employment market is still growing and is likely to do so for many years to come. In many ways, self-employed individuals have something of a cost advantage over their larger counterparts because they can be more nimble in addressing their cost base. Working from home, using Internet, the latest technology and minimising expenditure is now well within the grasp of many self-employed individuals.
The vast majority of lenders will recognise those with more than 15% equity in a limited company as a shareholder. The vast majority of self-employed people who operate their business through a limited company tend to have a far greater majority of the shares in issue. The structure can be diluted somewhat if there is more than one director or there is some kind of partnership structure.
There are a number of ways in which high street banks, private banks and specialist lenders will calculate the affordability factor. They will take into account array of different scenarios and it is up to your mortgage broker to present your finances in the best light and seek the best structure. Some of the more common options include:-
Very often you will see company directors taking out minimal income in order to retain as much money as possible in the business going forward. This allows them to build up capital within the business which can be used for expansion, future dividends or to flatten the peaks and troughs of profitability going forward. Assuming that a director (shareholder) takes out the minimum income required for their living costs then it may be more beneficial to recognise their share of taxable net profit per annum. In this scenario some lenders would go back over a number of years to find an average taxable net profit and use this as the basis for their affordability calculations.
In many ways, the fairest way in which to calculate affordability for a self-employed individual working through their company would be to add together salaries and net profit per annum. This would give an overall picture of the health of the company in recent years and many lenders will look towards averaging net profits and salaries over a predetermined period. The net profit figure would be before any dividend payments therefore giving a more beneficial picture.
The simplest way to calculate the affordability factor for a mortgage is to take the salary and the dividends received by a self-employed person. As we touched on above, this scenario is probably best served where the individual regularly pays out all company profits, after salary payments, in the form of dividends. However, there will be situations where profits are retained within the company as a means of smoothing year-on-year profit swings and leaving sufficient additional capital to cover salary shortfalls.
The use of director’s loans is a controversial subject when it comes to borrowings and affordability calculations. In the vast majority of cases directors loans are used as a form of early income. In effect the director will estimate the net profit at the end of the year and funds available for payment via dividends. Assuming they have erred on the side of caution and their assumptions are correct, they will simply declare a dividend at the end of the year which will be used to repay their directors loan. The amount available for dividend declarations at the end of the company’s financial year will also include retained profits from previous years. The use of director loans when calculating affordability is likely in the remit of private banks and more specialist lenders.
There may be situations where an individual does not need to pay annual dividends or draw earnings on a regular basis. They may be in a marriage, partnership or other relationship where the other parties are able to cover day-to-day living costs and expenses. So the idea of retaining profits within a limited company on a long-term basis may be attractive as this is akin to a savings plan. So, if a lender was to use the standard salary and dividend information to calculate the affordability factor this would be irrelevant. Therefore, averaging retained profits over a period of time would give an indication of the relative financial health of the business and figures to use in the affordability calculation.
The reality is that any business is susceptible to local and worldwide economy movements and as a consequence profits are unlikely to be constant. They may fluctuate from significant losses to significant profits or mimic the same pattern to a lesser extent. This is why it is sensible for lenders to use average annual profits over a period of time because choosing one period in isolation could indicate an extremely positive or an extremely negative scenario.
In the event that “more money is taken than is made in the year” this can only be taken from current and retained profits otherwise it would be classed as a directors loan. If the director’s loan was not paid before the year-end plus 9 months and 1 day then interest charges would accrue.
While some lenders will argue that looking at profit loss/income figures going back three years may be irrelevant if the business is changing, it does tend to give a fair picture. We can’t tell the future but we can look back and see what happened in years gone by. This is where the flexibility of lenders comes into play, high street banks are more structured with little room for manoeuvre while private banks offer more flexible and niche lenders tend to look at things from a very different perspective. As we mentioned above, it is the role of your mortgage broker to present your financial situation in the best light possible and attempt to secure a lending structure which best serves your situation.
Whether you are registered as self-employed with HMRC or operate your business through a limited company/partnership, you will come across the eternal problem faced by those who work for themselves. In order to maximise your potential mortgage borrowings you need to present the highest profit/income possible. However, in order to minimise your tax liabilities to HMRC you need to offset all expenses, utilise all allowances and minimise your profits in a legitimate manner. The eternal problem!
There are a number of ways to tackle this issue:-
If you have plans to source mortgage finance in the short to medium term then it would make sense to position your financial affairs in the best light. This would involve maximising your income and minimising your expenses to increase your net income/profit. Making use of more tax efficient methods to withdraw money from your company might also be useful. However, whichever way you decide to present your finances, once you sign-up for that mortgage it is your responsibility to cover the payments.
There may well be ways and means of reducing your short to medium term living expenses in order to secure mortgage finance. Whether this leads to a reduction in the number of holidays taken, downsizing your vehicle or simply reducing social life spending, this will all assist with your mortgage affordability calculation. In many ways this is the eternal conundrum for those looking to acquire their own property; downsizing their lifestyle expenses to accommodate the purchase of that dream home or trying to do both and potentially over-stretching their finances.
It is worth noting that there are perfectly legal means by which you can maximise your income, reduce your expenses and present your net income/profitability in a different light. Sometimes, it can be extremely beneficial to re-evaluate your finances, your income and outgoings and see where you can make savings. Very often those who are self-employed have little time to make those small tweaks which can save money in the short, medium and long-term, because they are concentrating on their everyday business activities.
When looking to secure any type of finance you will need to prove income and it is no different for the self-employed and mortgage applications. It will depend upon the way in which you are employed and how you are paid as to how you’re able to prove your income. As we mentioned above, the days of self-certification of income for self-employed individuals have long gone.
Some of the more common methods to prove income include:-
Whether you take a salary and dividends, you will still need to present proof of the salary element in the form of payslips from your company. These will show the traditional details such as national insurance number, rate of pay, accumulated income over the tax year, etc. As well as recent payslips you should receive a P60 at the end of each tax year detailing your gross income, deductions and net income. Whether you use PAYE software packages, or the simplified HMRC online services, the creation of a P60 is available at the touch of a button.
Formal PAYE software packages will create monthly payslips while with HMRC you will need to produce these on a manual basis. However, all of the information will be shown within the company’s HMRC account.
As we touched on above, there are various ways in which to structure your income which include salary, dividends and directors loans. While a payslip and P60 will clarify income received via a PAYE system, company accounts will give a broader picture of dividends and directors loans, as just two examples. They will also clarify retained profits and shareholder’s funds to which all shareholders will be entitled to a share of depending on their shareholding.
Company accounts will also give a detailed account of the company’s finances as at the year-end. When comparing and contrasting an array of financial indicators with years gone by, this can indicate trends, areas of improvement and general financial well-being.
Where you are self-employed and submit your own tax returns (or via your accountant) you will not have a formal P60. However, when submitting your tax return you will be able to download what is known as a SA302 which is effectively a copy of your self-employed tax calculations – detailing income, expenses and gross/net profit for the year. This will give mortgage lenders enough information to carry out their affordability calculation and decide whether they are able to provide you with mortgage finance.
Accountant certificates are predominantly used for company directors to confirm that their company accounts are in order and are a means of certifying an individual’s annual income. The fact that your accountant is signing the certificate as confirmation of your income encourages a high degree of confidence from your potential mortgage provider.
As we touched on above, there may often be a need to plan ahead, if you’re looking to raise mortgage finance, to enhance your profits and improve your chances of passing the affordability test. Many self-employed people ask us when is the best time to apply for a mortgage to stand the best chance of a successful application. While some of this will be down to the individual lenders, and what type of information they will accept, the individual can also assist in putting their best financial foot forward.
Some lenders will use the most recent set of accounts as the basis for their affordability calculation. This will reflect the most recent trading period and if there are any extenuating circumstances then they should be put forward with the accounts. For example you may just have signed a new contract after the accounts were lodged which could fundamentally change your income in the future.
It is perfectly legitimate to do some “window dressing” with regards to accounts as you approach the year-end. Ensuring that income due is paid prior to the year-end will increase your bank balance and make the accounts look more healthy. Delaying expenses until after your year-end will only make a difference under certain accounting practices. This is why many lenders will look over an 18 month period which will indicate movement pre-and post the previous set of accounts.
Those who are self-employed and submit their own tax return to HMRC will be aware that the tax year closes on 5 April with paper accounts due in October and an online return deadline of 31 January the following year. If you have passed 5 April but your tax return has not been lodged then you may well have a decision to make. If the previous tax year would shed a better light on your finances then you could use that as the basis for the affordability calculation. However, if the latest tax year (for which accounts have not yet been lodged) showed a stronger financial position then you should consider lodging your tax return early. Once the official return has been lodged you can take a copy of the HMRC calculations and use these as the basis for your mortgage application.
As more and more people utilise the Internet to trade on a worldwide basis we have seen an increase in the number of foreign companies created to produce income streams for UK nationals. While many of these companies may be trading buoyantly, and contributing a significant amount to overall income, there are issues to consider. These include:-
If you have company accounts from the UK, accounts from the US and accounts from Australia then there is every chance that they will operate under different accounting codes. This can see assets, income and profitability treated very differently in each country and giving different results. This is perfectly reflected in an ongoing court case between Hewlett-Packard and the former directors of UK technology company Autonomy.
Hewlett-Packard took legal action against the directors of Autonomy, suggesting that the financial information on which they based their takeover price was “misleading”. The directors of Autonomy have refuted all allegations amid suggestions that different accounting standards in the UK and the US may have caused some issues.
The fact that in some countries you do not need to prepare formal accounts for companies may at first glance seem like a significant cost saving. However, if you are looking to use income from countries where no formal accounts are required how do you prove income/profits? There are obviously ways and means of using overseas company data to create accounts under UK accounting standards which would help. Indeed if your accounts were prepared by one of the larger accountancy practices in the UK then they may well have offices overseas and be able to clarify financial figures fairly quickly. However, this can prove tricky and will often push mortgage applications towards the private banks and niche lenders.
The levels of taxation around the world will vary significantly and are a constantly moving variable. Therefore, it is difficult to compare and contrast accounts in areas where taxation is very different, accounting standards vary and potential liabilities when repatriating funds may in themselves create a tax liability. Again, this can push many mortgage applications towards the niche end of the market where greater flexibility is available.
In years gone by many people would dismiss potential currency issues with regards to overseas income. However, many have had their eyes opened since the 2016 Brexit referendum and the near 20% collapse in the value of sterling against the likes of the dollar and the euro. Therefore, when considering overseas income which may need to be converted into sterling there would be currency considerations. If you’re looking at foreign company accounts prepared six months ago under local currencies, would the income still have the same relative value if converted into sterling today?
While it will depend upon the level of foreign income and the impact on your overall net income, your local accountant may be to clarify the position fairly easily. If we are talking about a bigger operation, and a more complicated state of financial affairs, then you may require the services of one of the “big five”. However, whatever the scenario you will more than likely require the services of an accountant to effectively certify foreign income and foreign company accounts to be included in your affordability calculation.
There are other ways and means of clarifying non-UK income to be used as a variable in your mortgage affordability calculation. These include:-
This is simply a letter of confirmation from your accountant clarifying the position regarding foreign income and foreign companies owned or partly owned by their client. This assists in reducing any doubts regarding the clarity and detail of foreign company accounts and how they can be used by UK-based customers.
Rather than looking to clarify profits, which can be different under various accounting standards, simple confirmation of assets and liabilities from overseas companies may well suffice. This gives an idea of the “headroom” between assets and liabilities and the level of funding which may be available as and when required.
A number of wealthy individuals with income streams originating from around the world will look towards roll up income schemes as a means of delaying/mitigating tax liabilities. In simple terms, these are offshore funds which are able to hold foreign income on behalf of UK based companies/individuals. The roll up fund automatically retains the income and capital gains within the fund without the deduction of any tax. It is only when the funds are repatriated to, for example, the UK that a tax liability is created and a payment triggered.
While the vast majority of companies operating in the UK and overseas tend to attract their own definitive levels of taxation, there are some more difficult to analyse than others. If you look at for example:-
The taxation structure for gaming companies and the territories they can operating within, taking into account the Internet, can vary wildly. The UK government has a variety of taxation structures depending on the size and type of gaming company while some will choose to move abroad to areas such as Malta, where the taxation environment is more welcoming. It can therefore be difficult to ascertain whether gaming company funds held overseas can be transferred to the UK in a tax efficient manner.
There are other examples of unusual income streams relating to specific scenarios and specific careers. These include:-
Barristers tend to be self-employed within the chambers of a company although there are situations where they are salaried and employed directly by the company. Many would compare this to a tenancy arrangement whereby they pay a monthly (rental) charge to the chambers which is often a percentage of their monthly earnings. The chambers will also provide an array of basic services such as fee collection, diary management, promotion, invoicing, etc which all seems fairly straightforward.
Difficulties can arise for a number of reasons such as delays in trials, delays in payment, appeals, etc. As a consequence, when looking to apply for a mortgage it can be difficult for barristers to clarify an annual income within the boundaries of traditional affordability calculations. Lenders will likely need to use average earnings over a period of time, perhaps two or three years, and also take into account future work “in the book”.
While the offer of becoming a partner in a law firm is the icing on the cake for many lawyers/barristers it does come at a cost. You will need to invest your own money to secure the equity partnership position. While many people will go down the commercial loan route there may be tax efficient loan schemes within the law firm – which you will pay off over the years.
The majority of law firm partnerships involve a salaried element with a significant carrot of large commissions on a performance-related basis. As a consequence, in the early days of a partnership your financial situation may not look as rosy as it could as a consequence of your long-term investment. However, while increasing the ability to earn significant money above and beyond your salaried rate you will also (depending upon the individual structure) be entitled to a share of the firm’s overall net income. Again, depending upon the individual and their work schedule (as well as billing rates) the income of a law firm partner can be unpredictable.
There have been numerous examples of companies looking to outsource operations for a mixture of reasons. These situations may give employees the opportunity to go self-employed while undertaking the same role. In theory, depending upon the type of contract signed, there is still guaranteed income on a self-employment bases as well as the opportunity to take on other clients. On the flipside of the coin, the former employee will now be responsible for their own expenses, capital investment, etc which can initially lead to a reduction in income.
There may also be employment benefits that the individual will no doubt need to give up although there may be some negotiation about a form of “compensation” payment. While there are certainly positive elements to going self-employed it does instil a greater risk for security of income going forward. This may well impact the ability to raise mortgage finance in the short term even if the long-term prospects are relatively positive.
One of the major challenges for any recent start-up business is the initial requirement for capital investment in equipment, employees and services. This will likely mean that owners/shareholder/employees may need to accept a relatively low income in the short term while the business finds its feet and income starts to flow. The period of relatively low income will vary in different situations but traditionally it tends to be company owners/shareholders who bear the brunt of reduced capital available in the early days. Not ideal for those looking to raise mortgage finance.
When you operate your own business, through a company style set up or sole trader status, there may come a time when you are looking to sell your business or receive an unsolicited offer. Upon a sale very often you will see a significant element of the payment reduced via legal expenses, taxes and other financial liabilities. However, when looking to apply for a mortgage this can put you in a very tricky situation. If you leave the business after selling it then in effect you have no income stream. This will impact the ability to even carry out an affordability calculation. So, you may be relatively cash rich but under normal circumstances a lack of income could scupper your chances of raising mortgage finance.
In theory, the more straightforward self-employment situations can normally attract income multiples similar to those in salaried employment. This tends to be in the range of 4 to 5 times income although it can vary in certain circumstances. However, if you are able to put down a relatively large deposit then your chances of securing a mortgage will improve as could the headline interest rate.
This figure between four and five times income is not set in stone, especially when it comes to private banks and niche lenders who will take into account an array of other issues. There may be additional collateral available to secure funds, contracts secured may lead to a rise in profitability and there may be other non-traditional foreign income streams. This is where your mortgage broker will be able to negotiate the best deal for your situation.
Here at Enness, we have access to the wider lending market as a consequence of our independent status. This means that in more straightforward self-employment situations we can talk to high street banks, private banks and niche lenders. For more specialist scenarios the services of private banks and niche lenders are often more appropriate because of their greater flexibility in appreciating not only historic and current income but also future prospects.
Our experience shows that private banks tend to be more appreciative of directors loans which offer an initial tax-free income to cover mortgage payments. This can be repaid over a prolonged period of time or each year out of future income/share of profits. Traditional high street banks will almost certainly shy away from this type of situation which also takes into account the strength of the underlying business and future prospects. Very often the company accountant will need to provide various supporting paperwork and a justifiable reason for using this particular method of payment. It may well be that this particular method of payment covers the period between a short-term switch to greater income, significant profits and increased dividend payments.
As we climb up the self-employment income tree the situation tends to become a little more complicated the greater the income. This income could be split between different companies, different countries and even different currencies. Unlike many high street banks, which tend to take a relatively impersonal view of the prospects of self-employment mortgage applications, private banks and niche lenders are more flexible.
Due to our market connections, we have access to a wide range of lenders. While you may pay an additional premium for the more bespoke mortgage structures these do tend to attract a higher degree of risk for lenders. It is our role to plan ahead with your financial situation, show your figures in the best light and seek the most appropriate mortgage deal structure for your finances. There should also be a degree of flexibility involved which will allow you to make ad hoc payments as and when additional funding is available – something which is very common amongst the self-employed workforce in the UK.
So, why not give us a call today and we can discuss your situation in more detail, discuss the best mortgage structure for you and secure real-time rates from our lending partners.