Are you looking for a self-employed mortgage? You’re not alone!
This article will guide you through the key questions: Is your mortgage based on gross or net profit? How much can you borrow? We’ll demystify these concepts, and give you a clearer understanding of what lenders are looking for
What does gross profit mean?
Gross profit and net profit are terms used to describe the profits made at two different stages. It can be applied to individuals or companies.
When you’re a self-employed individual, be it a sole trader, partner in a business, or limited company director, your gross profit is the total revenue (income) minus the cost of goods sold, but it doesn’t take into account other expenses.
For sole traders, understanding your gross profit is essential as it gives an initial snapshot of your financial health prior to accounting for all other running costs.
You calculate this by subtracting direct costs like materials and labour from your total income. However, gross profit for sole traders does not include indirect costs such as rent or utilities.
In partnerships, the process remains similar. Gross profit for partnerships will still involve deducting direct costs from revenues earned by all partners combined. It’s crucial to ensure accurate record-keeping for each partner’s contribution to avoid discrepancies in profits distribution later on.
As a limited company director, calculating your company’s gross profit can be a bit more complex due to higher volumes of transactions and varying types of expenditures.
Nonetheless, the principle stays the same; you deduct cost of goods sold from total revenue generated within that tax period.
Gross profit only provides part of the picture when evaluating overall profitability or applying for mortgages as a self-employed professional.
It’s net profit that lenders look at because it reflects what truly trickles down after all expenses are accounted for.
What does net profit mean?
Net profit is essentially your business’s total income minus all its expenses, taxes and costs.
It’s the prime indicator of your business’s financial health and profitability.
When comparing net profit vs gross profit, the latter only deducts direct costs associated with producing goods or services from total revenue, whereas the former takes into account all operating expenses, interest paid on loans and taxes.
The concept of net profit becomes particularly relevant when applying for a mortgage as a self-employed person. Your net profit calculation forms the basis for assessing your mortgage eligibility.
Lenders use this net profit figure to evaluate how much you can afford to borrow.
Most lenders require at least two years of accounts or tax returns as proof of income. They consider this figure alongside other factors such as credit score and trading history. So if you’re a sole trader or company director hoping to secure a mortgage based on your business profits, it’s important that these documents reflect a healthy net profit.
Fluctuating profits will affect your application – lenders tend to average out profits over multiple years which could reduce the amount you’re able to borrow. On the flip side, demonstrating consistent growth in net profits year-on-year could increase your chances of securing a larger loan.
Which one do lenders use?
Lenders use the net profit, not gross, to assess affordability for loan applications. This is the lenders’ preference as it provides a more accurate picture of the available funds at your disposal after all expenses have been accounted for.
This is the best way for them to look at your true affordability.
If we take the simple case of a plumber who fits new bathrooms and showers.
At the end of the year the money they have received is £150,000. But this is not their income.
£60,000 of this related to parts and fittings supplied on jobs. Another £20,000 went on insurance, travel, marketing etc.
Leaving a net profit of £70,000, before personal tax.
Before tax or after tax?
It’s easy to get muddled between net profit and net income, and the figures before and after tax.
Essentially, the lenders will look to use an individuals gross personal income, before personal tax. This applies equally to employed people and the self-employed.
If you are a self-employed sole trader or partner then these figures are relatively straightforward to come by.
But for a company director the process is slightly different. A limited company can only distribute profits net of corporation tax.
So if the company made £120,000 before taxation and then paid £20,000 in corporation tax, it’s net profit for the financial year would be £100,000.
This £100,000, when allocated to a shareholder is their gross income, before any personal tax liability is worked out.
How much can you borrow?
The amount you can borrow largely depends on your self employed net income, with many lenders using income multipliers for affordability assessments. This means they take your annual net profit and multiply it by a set figure, typically ranging from four to five times your income.
Example: £50,000 income x 4 = £200,000 mortgage
Calculating affordability isn’t just reliant on your net earnings though. Other factors including the size of your deposit, credit history, and existing financial commitments affect how much you could be offered.
In terms of deposits, this is where loan to value ratio considerations come into play. The larger your deposit or equity in a property, the lower risk you pose to lenders which can lead to better mortgage deals.
As a self-employed individual seeking a mortgage based on net profit, providing comprehensive income documentation is crucial. You’ll need at least two years’ worth of accounts or tax returns as evidence of steady income – although some lenders may accept less under certain circumstances.
How to prove your income
You’ll need to gather certain documents to effectively prove your income when applying for a loan. This process of calculating income can differ depending on whether you’re a self-employed sole trader, partner, or company director.
As a sole trader or partner, your supporting documents will typically include certified accounts and HMRC SA302 forms from the past two to three years.
These forms show your net profit which is crucial for lenders in assessing affordability. Keep in mind that lenders often average the last two to three years of your income due to possible fluctuations.
If you’re a limited company director, it’s slightly more complex. Besides the usual accounts and SA302s, you might also need business bank statements and evidence of dividends drawn from the company. Remember that some lenders might also consider retained profits as part of your income.
For multiple company owners, providing self employed evidence can be even more challenging due to irregular incomes sources across different businesses. You may have to supply additional paperwork such as contracts or invoices to demonstrate consistent earnings.
What are retained profits?
‘Retained profits’ refer to the profits that a limited company keeps in its reserves after paying out dividends, which can then be reinvested back into the business.
These retained funds are essential for business growth, potentially serving as a catalyst for expansion and innovation.
But they can also be used to provide dividend income for shareholders in the future.
Let’s look at a very simple example.
At the end of it’s financial year, a limited company has £100,000 distributable profits, after corporation tax.
The shareholders only require £60,000 at this time, and so ‘leave’ the remaining £40,000 in the business. These are retained profits.
It is possible for the business to use this money for investment and growth opportunities. But the undistributed profits belong to the shareholders and so some lenders will acknowledge this and allow them to be used as earnings, for the purposes of calculating a maximum mortgage.
The role of a mortgage broker
The fundamental role of a mortgage broker is to find the most suitable mortgage for a client, from all those available.
But getting to that point can take a significant amount of work, and is particularly true for self-employed borrowers.
As we’ve seen, the elements of net and gross income can be confusing, and difficult to determine which figure a lender is looking for.
Drake Mortgages have many self-employed clients and business owners, a good number of these have multiple streams of income.
It’s our job to dig in to these figures and then make sure everything looks right before we put them in front of a lender. Sure, we can’t change your declared income from last year.
But different lenders have different attitudes to risk and what income they are prepared to accept.
As experienced advisers its our job to know the different criteria that’s available and find one that best matches what you need.
As a whole of market broker we can deal with all lenders. But its the years of experience that enables us to help and guide those in self-employment, when the high street banks say no.
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