If you work, you know you have two types of income – gross income and net income. When questioned, you probably know your gross monthly income or yearly income rather than the net, right? That’s what lenders think too. It’s not the reason they use your gross salary rather than your net, but it does play a role.
Calculating Your Gross Income
Calculating your gross income is rather simple. If you are paid a salary, you take your annual salary and divide it by 12. For example, if you make $60,000 per year, your gross monthly income is $5,000.
If you work on a per-hour basis, you will calculate your gross monthly income a little differently. Let’s say you consistently work 40-hours a week and make $20 per hour. You would do the following:
40 hours x $20 = $800
$800 x 52 weeks = $41,600
$41,600/12 months = $3,467 per month
If you don’t work 40 hours, you would replace the 40 with the average number of hours you work per week.
What is Gross Income?
Gross income, as we showed above, is the money you make before taxes. It’s the figure you know right off the top of your head as it’s the one your employer quoted when they offered you the job.
Net income is your gross income minus any deductions, such as taxes and retirement account contributions. This number may vary and isn’t something you will readily know off the top of your head.
Why Lenders Don’t Consider Net Income
Aside from the fact that net income would be harder to differentiate, the lender has other factors they consider. Your income is just one piece of the puzzle. Even though they qualify you based on money you don’t really take home, they look at other things too.
For example, your credit score plays a vital role in your approval. Your credit history lets a lender know how financially responsible you are with your money. If you have a lot of late payments or your credit score is very low, they will not consider you for a loan, no matter what your income is at that point.
If, on the other hand, you have a timely payment history and you have a high credit score, lenders know that you are financially responsible. This allows them to use your gross monthly income for qualifying purposes.
In addition to your credit score, lenders also look at your debt-to-income ratio. Your front-end ratio is the total housing payment compared to your gross monthly income. This includes the principal, interest, taxes, and insurance you’ll pay. Depending on the program the front-end ratio may be able to be anywhere between 28 and 31%.
The back-end ratio is your total monthly debts compared to your gross monthly income. This includes any payments you have, such as credit cards, car payments, or student loans. The lender adds this to the proposed mortgage payment to come up with your back-end or total debt ratio. This amount can usually be between 36% and 43%.
These factors help lenders determine along with your gross income if you qualify for a loan. However, lenders can qualify you based on what they see on paper. Only you know what you can truly afford. You don’t have to take the full loan amount that a lender offers. You are free to ask for a lower loan amount if that’s all you need or all that you can comfortably afford. You know your net income and where that money goes as soon as it hits your account.
You are in charge of your finances and the amount of the mortgage you want to take on at any time. You should also shop around with different lenders to find the program that suits you the best both now and in the future.