Self-Employed and House Hunting? This is a Must-Read Before Applying for a Home Loan

Self-employed borrowers face a unique set of challenges when seeking a home loan, particularly when it comes to how income is assessed, but select group of lenders now offer more progressive policies that often result in much higher borrowing potential.

For self-employed Australians, applying for a home loan can be a more complex process than it is for salaried employees. One key reason is how lenders assess income. Rather than relying on predictable PAYG payslips, banks assess income through tax returns, business financials, and sometimes even BAS statements. A central policy adopted by many lenders involves averaging the last two years' trading figures to determine a borrower's borrowing capacity.

In this article, we’ll explore how this income averaging policy works, when it’s applied, what exceptions exist, and how it affects loan outcomes using a real-world example. We’ll also look at the more flexible alternative used by some lenders who are willing to consider just the most recent year’s income — a potentially game-changing approach for many business owners.

Why Do Banks Use Income Averaging for a Self-Employed Home loan?

Self-employment can come with fluctuating income year-on-year, depending on the business cycle, market conditions, or operational changes. To mitigate risk, most lenders in Australia adopt a conservative approach: they review the last two years of tax returns and average the income. This method smooths out any income spikes or drops and gives the lender a broader picture of the business's sustainable performance.

This is often called the two-year average policy, and it is standard among major banks and traditional lenders.

How the Income Averaging Policy Works

1. Income Evidence Required

To assess income under the averaging policy, lenders usually require:

• The last two years of personal tax returns and Notices of Assessment

• The last two years of business tax returns and financial statements

• Business Activity Statements (BAS), if required

  
  

2. Calculate Net Profit or Add-Backs

For sole traders, the lender assesses the net profit shown on the personal tax return.For company or trust structures, the lender considers:

• Wages paid to the applicant (if any)

• Share of net profit (dividends or distributions)

• Non-recurring expenses or add-backs like depreciation or interest expenses (if refinancing).

  
  

3. Averaging the Two Years

Once income is confirmed, the lender adds the income from the most recent two financial years and divides it by two. If the most recent year is lower than the previous year, most lenders will use the lower figure only, not the average — this is known as a declining income policy and is another layer of conservatism.

Example: Averaging $100,000 and $140,000

Let’s assume a self-employed applicant submits the following net income on their tax returns:

• FY2023: $75,000

• FY2024: $120,000

  
  

Step-by-Step Calculation:

1. Add both years:$100,000 + $140,000 = $240,000

2. Divide by 2 to get the average:$240,000 ÷ 2 = $120,000

3. Lender assesses the applicant as earning $120,000 per annum.

This $120,000 figure becomes the baseline used in serviceability calculators to determine how much the borrower can afford to repay. The lender will then consider:

• Existing liabilities (credit cards, car loans)

• Living expenses (declared or benchmarked)

• Interest rates (often a higher "buffer" rate)

• Loan term and deposit size

Let’s assume the borrower has no other debt and modest expenses. Based on standard serviceability formulas, a borrower earning $120,000 per year might qualify to borrow approximately $450,000 and $470,000, depending on the lender and current rates.

The Alternative: Using Just the Most Recent Year

While the income averaging method is dominant among banks, some non-major banks, non-bank lenders, and specialist lenders now offer an alternative — assessing borrowing capacity based only on the most recent year's income, especially when the applicant can show business growth or an upward income trend.

This is particularly helpful for:

• Newer businesses gaining momentum

• Self-employed borrowers recovering post-COVID

• Applicants with a low-income year due to one-off events (e.g. illness, equipment failure, or parental leave)

This approach reflects the belief that the most recent year is a more accurate representation of the business’s current performance.

Same Example: Using Only FY2024 Income

Let’s revisit the same figures:

• FY2023: $75,000

• FY2024: $120,000

If a flexible lender agrees to use only FY2024’s income, the assessable income increases from the $120,000 average to $140,000.

Impact on Borrowing Capacity:

With $140,000 income and the same assumptions (no other debts, modest expenses), the borrower may qualify for somewhere between $580,000 and $610,000 in borrowing — a difference of around $140,000 more than under the averaging policy.

This can make the difference between:

• Buying the desired home now vs. waiting another year

• Qualifying for the loan vs. getting declined

• Borrowing for a larger deposit or investment property

Pros and Cons of Each Approach

Policy	Pros	Cons
Two-Year Average	Favours stable, long-term businesses; used by most major banks; lower risk profile	Penalises applicants with a recent income uplift; can significantly reduce borrowing
Most Recent Year Only	Allows higher borrowing if current income is strong; helpful for growing businesses	May not be accepted by all lenders; could require more evidence or explanation

How to Maximise Approval as a Self-Employed Borrower

To improve your chances of success:

1. Prepare Full Documentation – Ensure tax returns are complete and up to date.

2. Work With a Mortgage Broker – A good broker knows which lenders use which policies and can present your case accordingly.

3. Consider Lender Flexibility – If your income is rising, consider applying with a lender that allows single-year income assessment.

4. Explain Fluctuations – Provide written explanations of any sharp income increases or decreases.

5. Watch the Timing – If FY2024 is much stronger, wait until that year’s tax return is lodged before applying.

   
   

Conclusion

Self-employed borrowers face a unique set of challenges when seeking a home loan, particularly when it comes to how income is assessed. The traditional two-year averaging method used by many Australian banks can significantly limit borrowing power for growing businesses or those with a one-off down year. However, a select group of lenders now offer more progressive policies that use only the most recent year’s income, often resulting in much higher borrowing potential.

In the earlier example, switching from the average ($97,500) to the most recent income ($120,000) could unlock up to $150,000 more in borrowing capacity — a critical difference in a competitive housing market.

Working with a mortgage broker who understands these lender differences can make all the difference in getting the right loan structure and achieving your property goals sooner.