A side job can be a fantastic way to increase your income, pay off debt, and increase your financial security. But gig work, like a side job, may also be affecting your credit without you realizing it.
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If you plan to apply for a car loan or buy a home in the future, you’ll need to understand and prepare for how your job could affect that process.
Informal work is naturally unpredictable and its income fluctuates, not only from month to month, but from year to year. This is in direct contrast to the predictable income that lenders traditionally use to evaluate creditworthiness. Scott Bialek, co-founder of Hurst Lending, explained that when your income is constantly changing, it is difficult for lenders to calculate a debt-to-income ratio, which is one of the main factors they use when evaluating credit applications.
“Insurers often calculate your qualified income based on your lowest earning months, rather than your average,” he explained. As a self-employed person, your lowest-income months may not accurately reflect your actual income, so you may not qualify for the credit you apply for. “Providing a year-to-date profit and loss statement signed by a certified public accountant is necessary to negate this assumption.”
“Documentation is the only way to close the gap between your reality and your rigid guidelines,” Bialek said. “A statement signed by an accountant has a weight that self-prepared spreadsheets will never have.”
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According to Garth Sheriff, president of Sheriff Consulting, artificial intelligence is shaping the underwriting process and could make things worse for freelancers. He explained that gig workers are required to provide much more documentation during the underwriting process than employees, but gig worker applications are still processed poorly. “As underwriting at financial institutions moves toward automation and artificial intelligence, this will get worse due to the bias of viewing employees as less risky than freelancers,” he explained. That bias is due to the uncertainty of cash flows that come with commissioned work.
Freelancers should be prepared to provide tax returns, credit scores, a list of clients and income details, plus lenders may require additional documentation. Sheriff explained that while credit score remains key to approval, most lenders also focus on future earnings when evaluating the risk of granting a loan to an applicant.
Certain lenders are better equipped than others to evaluate applicants with earned income. According to Bialek, online lenders that focus on cash flow often approve freelance applications much faster than traditional lenders. “These modern financial companies review your bank statements to verify income instead of requiring W-2 forms,” he explained. “Typically, they have a higher chance of approval because they understand how sharing economy payments work.”
Bialek has found that connecting your bank account directly can also help significantly speed up the review and approval process.
Before applying for credit, Bialek recommended auditing your tax returns for the past two years to verify that your net income appears healthy enough to be approved. “Lenders look at your bottom line after deductions, rather than your gross income, because they need assurances regarding your ability to pay,” he explained.
While many freelancers write off all expenses to reduce their tax bills, doing so may disqualify them from financing large purchases. Bialek explained that you may need to claim fewer deductions this year, which could increase your adjusted gross income to meet the lender’s debt-to-income ratio requirements. “Showing a profit on paper costs more in taxes now, but guarantees the loan later,” he said.
Bialek recommended immediately requesting an adverse action notice from a lender if your application is denied. Federal law requires the lender to provide a document explaining why it denied your application. “Review that notice carefully for errors on your credit report or income verification,” he suggested.
Even if you don’t foresee the need to apply for credit in the near future, you can take steps now to become a more competitive applicant.
The sheriff recommended that crowdworkers work with a certified public accountant or financial advisor to put together a formal business case document. When you apply for credit with any financial institution, you can submit that package as part of your application.
This might also be the time to reevaluate how you deduct expenses on your tax return to reduce your tax bill. If you plan to make a large purchase, like a home, and its tax deductions significantly reduce your income, it could negatively affect your chances of getting approved. Be sure to speak with a tax professional for help specific to your situation, and when possible, plan for large purchases that will require financing several years in advance.
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This article originally appeared on GOBankingRates.com: 3 Ways Your Side Hustle Could Be Hurting Your Credit Without You Knowing
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