When you apply for a mortgage, your lender will ask about your gross income. You might be surprised to learn that this isn’t the money you bring home on your paycheck. It’s the full amount of your income before taxes and other deductions.
Keep reading to learn why lenders use this number and which number you should use for your own budget.
Why Lenders Use Gross Income
The main reason lenders rely on your gross income rather than the net income is its reliability. Your net income is your total salary minus taxes and other deductions. These deductions could change often, so using your net income might give lenders inconsistent results. For example, if your company changes insurance plans or you change your tax filing status, your net income may change. Even if it’s only a $100 difference, it may still alter your ability to secure a loan.
Another reason lenders use gross income is that it’s a number you likely know off the top of your head. If someone asks you how much money you make per year, you probably know the salary your employer pays you better than the amount of your paycheck and how it converts into your annual salary. For example, it’s much easier to rattle off $75,000 per year rather than figuring out how your $5,267 monthly check converts into an annual salary.
How Lenders Use Your Gross Income
Lenders use your gross income to determine the maximum amount of your loan payment. Each loan program is different, but as a general rule, you can use the conventional loan guidelines of 28% and 36%. In other words, you can have a mortgage payment that is up to 28% of your gross monthly income. But lenders will also look at your total debt ratio. This is the total of all of your monthly debts including your mortgage payment – this figure shouldn’t exceed 36% of your gross monthly income.
Why You Should Focus on Net Income
Now just because a lender focuses on your gross income doesn’t mean you should use this figure. Your net income is the money you actually take home. This is the money you can use to pay your bills. You want to make sure that the mortgage payment you take on fits into that budget.
A good way to figure it out is to put the potential mortgage payment into your monthly budget. Are you comfortable with the payment? Do you have enough money left over after paying your bills to cover your living expenses?
If you focused on your gross monthly income, you might take on a mortgage payment that exceeds what you bring in or what you can comfortably afford. Some people don’t want to take on debts that eat into their disposable income. Many borrowers don’t want to live paycheck-to-paycheck. These are all reasons why you should focus on the net income to make sure you are taking on a loan you can afford.
Your lender will focus on your gross income, so make sure you have those numbers handy when you apply for a loan. But when you think about what you can afford, your net income is a better figure to consider to ensure that you only take on what you can afford.