A side hustle can be a great way to increase your income, pay off debt, and increase your financial security. But gig work, like a side hustle, may also affect your credit without you being aware of it.
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If you’re planning to take out a car loan or buy a home in the future, you’ll need to understand and prepare for how your gig work may affect the process.
Gig work is inherently unpredictable, and your 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 assess creditworthiness. Scott Bialek, co-founder of Hearst Lending, explained that when your income fluctuates constantly, it’s difficult for lenders to calculate your debt-to-income ratio, which is one of the main factors they use when evaluating credit applications.
“Authors often calculate your eligible income based on your lowest income months rather than your average income,” he explained. As a gig worker, your lowest income month may not accurately reflect your actual income, so you may not qualify for the credit you’re applying for. “You need to prepare a year-to-date profit and loss statement signed by a CPA to avoid this assumption.”
“Reference is the only way to bridge the gap between your reality and their strict guidelines,” Bialik said. “A statement signed by an accountant carries weight that self-prepared spreadsheets will never have.”
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According to Garth Sheriff, CEO of Sheriff Consulting, artificial intelligence is shaping the underwriting process, and that could make things worse for gig workers. He explained that gig workers have to provide more documentation during the application process than employees, but gig worker applications are still poorly processed. “As banking in financial institutions moves towards more automation and AI, it will be exacerbated by the bias that employees have less risk than gig workers,” he explained. This bias is due to the uncertainty of cash flows that come with gig work.
Gig workers must be prepared to provide tax returns, credit scores, client lists and income details, and lenders may require additional documentation. Sheriff explained that while a credit score is still key to approval, many lenders also focus on future income when assessing the risk of lending to an applicant.
Some lenders are better at evaluating applicants with gig income than others. According to Baylick, online lenders that focus on cash flow often approve applications from freelancers more quickly than traditional lenders. “These modern financial firms review your bank statements to verify income instead of asking for W-2 forms.” He explained. “You typically find higher approval problems here because they understand how gig economy payments work.”
Bialik has found that linking your bank account directly can also help speed up the review and approval process significantly.
Before you apply for the credit, Bialek recommends auditing your tax returns from the past two years to verify that your net income looks healthy enough for you to be approved. “Lenders look at your bottom line after deductions, rather than your gross income, because they need certainty about your ability to repay,” he explained.
While many freelancers will cut any expense to reduce their tax bills, doing so can disqualify them from financing large purchases. Bialik explained that you may need to claim fewer deductions this year, which can increase your adjusted gross income to meet the creditor’s income requirements. He said: “Showing a profit on paper costs more in taxes now, but it saves debt later.”
Bialik recommends requesting an adverse action notice from the lender immediately if your application is denied. Federal law requires the lender to provide a document explaining why they denied your application. “Review that notice carefully to spot any errors on your credit report or income verification,” he suggested.
Even if you don’t anticipate needing to apply for credit in the near future, you can take steps now to make yourself a more competitive applicant.
Sheriff suggested that gig workers work with a CPA or financial advisor to create a formal business case document. When you apply for credit with any financial institution, you can submit this package as part of your application.
It may also be time to re-evaluate how you reduce your tax return expenses to lower your tax bill. If you anticipate making a large purchase, such as a home, and your tax deduction significantly reduces your income, you could negatively affect your chances of approval. Be sure to talk to a tax professional for help specific to your situation, and when possible, plan big purchases that will need financing years in advance.
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This article originally appeared on GOBankingRates.com: 3 Ways Your Side Interests May Be Hurting Your Credit Without You Realizing
