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    The hidden consequence of self-employment: Barriers to borrowing money

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    Whether you’re a freelancer, contractor, or small business owner, there’s pros and cons of being self-employed. The most famous pros — cited by almost every article and blog post on self-employment — include flexible work schedules, tax advantages, and more control of your own life. However, less commonly cited in the consequences are the increased barriers to getting a loan.

    A mortgage, line of credit, or auto loan that would normally be approved easily for someone with a nine-to-five job can vanish as soon as you decide to be your own boss — even if your credit score remains pristine. Without a stable income watering your bank account every other week, many lenders feel insecure in providing you with a loan.

    Even if you’re a contractor, a lender may fear that you’ll be unable to secure your next contract and thus unable to make your next payment. With small businesses, the customers that you have today may not be here tomorrow.

    Most lenders require two years of tax returns

    If you’re still in the nine-to-five program and are thinking of hitting the road solo, it’s best to have any loans approved while your income is steady. After switching to the life of the self-employed, you may not qualify for a loan for the next two years, as lenders often ask for two years of tax returns.

    The lender also won’t consider income that isn’t on your tax return. This creates a conflict. While self-employed, you want to understate your income to pay less tax. However, you also want a strong taxable income to qualify for a loan. If you really need that approval, it may be best to lay off on the expenses and deductibles for the year.

    If you’re still in the nine-to-five program and are thinking of hitting the road solo, it’s best to have any loans approved while your income is steady.

    Self-employment means higher interest rates

    If you’re self-employed, your unstable income results in lenders seeing you as a higher risk. This naturally leads to higher interest rates to reduce the lender’s risk. Interest rates are also higher because you may not qualify for A-lender loans (typically large banks), and thus require a private lender.

    A-lenders use computers to scan loan applicants, and that system doesn’t exactly favour the self-employed applicants. However, with private lenders, you’re likely talking to a real person. This person can better assess your situation in a more holistic sense than a computer can and approve of a loan that others have denied — at a higher interest rate, of course.

    Online lenders are just another form of private lending but are more convenient. Instead of meeting different private lenders at their office, online lenders are a button click away. Additionally, many online lenders specialize in loans to self-employed individuals. They fill niches as specific as short-term restaurant loans or long-term loans for freelancers who want capital for their poorer months. Some popular online lenders include MyNextPay, LendingTree, and LendingClub.

    Reducing your perceived riskiness

    Two common ways to have lenders perceive you as less risky is with collateral (a secured loan) or with a cosigner.  A secured loan is when your loan has an asset or collateral that can be repossessed in case you default on your loan. This is common with mortgages, auto loans, and business loans. With mortgages and auto loans, there is the obvious asset of the house or car(s) that can be repossessed. In a business loan, anything bought to run the business such as furniture or computers can be repossessed.

    This contrasts an unsecured loan where the lender has nothing to fall back on and where the loan approval is contingent on your financial history and income. If you don’t pay the loan back, the creditor doesn’t have a right to repossess anything. However, your credit score will take a big hit.

    A cosigner is another way creditors can assure their repayment, even if your income isn’t steady. A cosigner is someone who guarantees the repayment of the loan in case you default. If this person has a steady income and/or a strong financial history, it can make getting a loan a breeze. This is commonly a spouse or close family member — someone you trust and who trusts you. The cosigner essentially takes on part of the risk for the lender.

    If you’re looking to become your own boss, make sure to have your loans approved before jumping out of the nine-to-five lifestyle. Getting a loan as a self-employed person is tough but won’t be impossible. Private lenders, a secured loan, and/or a cosigner will increase your chances of getting approved for some much-needed credit.

    Originally published July 18, 2019, updated August 25, 2023

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