Iain Rankin explains how small business owners who may have a difficult time with mortgage applications can strategize and give themselves the best chance of approval.
It is often the case that mortgage lenders will view those in self-employment or directors of small companies as high risk compared to those in employment.
Ironically, once a small business has been established, the loss of one particular customer may have a negligible effect, whereas an individual in employment relies on only one income stream. We could, therefore, conclude that at least some small business owners are actually lower risk, but ultimately lenders want to see stability (by which I mean regular, incoming payments) before offering a mortgage. Whereas an employee is able to provide proof of a guaranteed monthly payment, small business income can vary seasonally, or even randomly.
Mortgage difficulties
For this reason, it is often the case that a company director will have more difficulty gaining a mortgage than an employee of the same company. In addition to the favourably lower dividend tax rates offered by limited companies, one of the key benefits is the ability to fully utilise the income tax basic rate band each tax year by carefully timing when withdrawals of profits are made. Although minimising earnings by this method is commonplace and completely legal, it would be more beneficial to maximise earnings if a director seeks to increase their likelihood of obtaining finance for a property purchase.
Each mortgage lender has their own set of criteria by which they will assess the eligibility of company directors or self-employed individuals. For example, you may find that while a handful of lenders may consider retained profits within a company, the majority will ignore this completely. Some lenders can be rigorous; others are relatively straightforward.
Financial documents
If a business owner’s income is derived solely from their business, it is crucial that the financial statements of the business are in good shape long before a mortgage application is made. While those in employment are normally paid via PAYE and are easily able to provide P60’s for each tax year, this is not often true for company directors. For maximum tax-efficiency, a company director will often take a small salary, with the rest of their income being withdrawn as dividends. In this instance, a P60 will not accurately represent the director’s total earnings.
Form SA302 - comprised of the individual’s tax calculation and tax-year summary – is one of the best ways to prove income. The form SA302 relates to an individual rather than a company, confirming the total income (salary, dividends or otherwise) earned by the individual. Similarly to self-employed individuals, a company director is required to report dividends via self-assessment tax returns. Whether the applicant is a director or a sole trader, the lenders are likely to request provision of an SA302 form.
For self-employed businesses, the SA302 forms will be essential, but in the case of single-person companies some lenders are satisfied to see company accounts alone. The accounts are not only secondary proof of the director’s salary; they also serve to confirm a company’s net profits after-tax. If the mortgage lender considers retained earnings left within the company, these will also be detailed in the accounts. From experience, the applicant may still be asked to provide copies of other documents in addition to accounts e.g. finalised self-assessment tax returns.
A steady track record?
Whatever documents are requested, it is usually a safe bet to assume that the average lender will want to see at least two – but often three - years of finalised SA302s and/or accounts. For any companies which have been trading for only one year, it must be noted that unless the company accounting period runs alongside the tax year, the first year of trading will fall into two different tax years. In this situation, many lenders will not consider an application until the second set of accounts have been filed.
For those who have incorporated what was previously a sole-trader business, in some cases it is possible to provide SA302’s as proof of income for any tax years prior to incorporation. This is advantageous if the company has not yet completed two or three accounting periods. Sadly, if the same business had been incorporated upon commencement of trading, it is likely there will not be sufficient information for many lenders, and the director may struggle to secure a mortgage.
Three years of financial statements will grant access to the widest range of mortgage lenders. It goes without saying that for the application to be successful, these statements must prove that the applicant has a steady, stable income which is in line with the amount they are looking to loan.
Remuneration strategies
As mentioned earlier, company directors are able to legally minimise their earnings in the tax year, either by delaying or by bringing forward withdrawals of dividends.
However, providing that the company has sufficient profit to distribute, the director can also maximise their earnings while paying less tax than a sole trader or partnership business might. This can offer a significant advantage in tax planning for a mortgage, as it allows the director to build up reserve profits to be withdrawn in the years running up to the mortgage application.
Example: Company owner’s mortgage application
Alex, the director of a single-person company, wishes to purchase a property valued at £150,000; he is prepared to put a 10% deposit up front, taking the total loan amount to £135,000. Typically, lenders will only loan between 4.5 to 5 times the individual’s income. To be on the safe side then, Alex should have at least £27,000 of income each year to be considered for this mortgage.
For simplicity, suppose that the company year runs in line with the calendar year and annual turnover is distributed fairly evenly between each month. We’ll say that in the last two years of trading, the company had after-tax profit of £50,000 per year. In each of these years, Alex took no salary but withdrew £30,000 as dividends.
Over the last two years, the company has retained a total of £40,000 in residual profits. If business profits drop to £30,000 in the third year, Alex would still be able to top up his earnings by withdrawing the reserve profits as dividends. This keeps his SA302 in good shape for his mortgage application.
But if Alex had instead been operating his business as a sole trader, his SA302 would show two years of steady earnings, followed by a 66% drop in earnings. This is quite the opposite of what mortgage lenders want to see and so could hurt Alex’s application.
To summarise, whether they are operating via a limited company or as a sole trader, if a business owner is looking to apply for a mortgage they must plan ahead wherever possible. Ideally, they should aim to rid their business of any unnecessary expenditure, maximise dividend take and ensure that their plans must be brought into action at least two or three years before the intended date of the mortgage application.
It should be noted that lenders will pay close attention to a company’s balance sheet to ensure the company is solvent; if the company owes more than it owns, a mortgage lender is likely to view this as high risk.
Practical Tip:
If you are a sole trader planning to take out a mortgage, incorporation can offer increased flexibility. However, you must determine whether this is right for your business as a whole. Speak with your tax adviser to discuss your options
