mortgage income documentation Archives

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.

If your income is rather sporadic or you don’t have paystubs/W-2s to prove your income, it may be hard to get a mortgage. Prior to the housing crisis, lenders were very lenient with who they lent money to for a mortgage. Today, it’s a different story. The housing crisis killed the idea of accepting any type of mortgage without proof of how you will pay for it.

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It all comes down to the Qualified Mortgage and Ability to Repay rules. The Qualified Mortgage Act requires that lenders make sure applicants meet certain requirements before they can take out a loan. The rules are strict, which means fewer borrowers will qualify. In exchange, however, lenders are protected from lawsuits should a borrower default on their loan and lose their home.

Not all lenders follow the Qualified Mortgage rules, though. They choose to take a chance and allow less stringent guidelines. However, no matter what a lender decides, they have to follow the Ability to Repay Rules. Basically, this means the lender can prove beyond a reasonable doubt that you can afford the loan. In other words, they need proof of your income.

Don’t worry, though, there are ways around it. You don’t have to be the paystub and W-2 employee to get a mortgage. There are other ways you can prove your income and still get a loan.

Use Your Tax Returns

If you are self-employed, lenders will need to see your tax returns. They’ll usually ask for two years’ worth of tax returns. This allows them to see your income over that time and take an average. It also allows them to see what expenses you write off, as they will take those expenses right off your income as well.

Your expenses are one area that your tax returns could hurt you. Even though it’s perfectly legal to write off certain expenses to lower your tax liability when you own a business, it could hurt you when you apply for a mortgage. Lenders are required to use your net income reported on your tax returns, not the gross income you claim. It’s to your advantage to hold off on writing off those expenses in the year or two before you know you will apply for a mortgage.

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Use Your Bank Statements

If your tax returns won’t yield the greatest results when you apply for a mortgage, consider using your bank statements as proof of income. This works well if you are self-employed or even if you work for someone but are paid commission or bonuses.

Your bank statements need to show consistent deposits in order for the lender to use the income as you state it. Regular deposits at the same time each week, every other week, or month will show the lender the consistency of your income. Lenders often use this money at the value of the deposits unless there is a reason to deduct unreimbursed expenses.

You’ll Need Compensating Factors

No matter which category you fall into, you’ll need to show the lender that you have compensating factors. For them to take your loan at face value without standard proof of your income is a big risk for them. In order to offset this risk, they need to know that you are a financially sound risk. You can prove this by:

High credit score – The higher your credit score, the financial responsibility you show the lender. Try increasing your score as much as possible during the time leading up to your mortgage application. The lower your credit card balances, and the more timely your payments, the better your score will be.
Low debt ratio – The lower your debt ratio, the lower risk you pose to a lender. If a lender is willing to take your alternative form of income, they want to know that you are not overextended on your debts. Staying below the program maximums will help your chances of approval.
Stable income – It’s hard to have stable income when you work for yourself or on commission, but making it as stable as possible is important. However, there are ways to prove stability even before you started your own business. The more experience you have in the industry you open your business in, the more reassurance it gives the lender that you are a good risk.

Proof of income is a vital component of the approval process for a loan, but there are ways around the ‘normal practices.’ You’ll need to find a subprime or alternative lender that is willing to think outside of the box, though. Your big box banks are going to have the stricter guidelines when it comes to income. It’s the smaller banks that have the ability to make their own rules because they keep the loans that will suit you best in this case.

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Is Gross Income Before or After Taxes?