Why Do Lenders Use Your Gross Pay

Written by Posted On Thursday, 22 February 2024 00:00

This might seem kinda curious that lenders don’t count how much money you take home each month when determining affordability. Seems counterintuitive, does it not? I mean, after all, you pay your bills with the money you take home, not with the gross pay shown on your paycheck stub. And while it does seem a bit odd that lenders don’t look at your net pay each month, there are definite reasons for it.

For most every loan program available today, lenders must determine affordability. This is accomplished by comparing your monthly income with your monthly bills plus the new payments associated with a new mortgage. The monthly bills that count each month are things such as a car payment or installment loans. It does not consider everyday expenses like food or utilities. For your mortgage payment, lenders add up the principal and interest payment along with  monthly allotment for property taxes, hazard insurance and mortgage insurance (when needed.)

These comparisons are referred to as debt ratios and they look at the amount of monthly expenses compared to gross monthly income. When you add the housing payments into the mix, you now have two debt ratios, one is referred to as the ‘front’ ratio which is your total mortgage payment and then the ‘back’ ratio which is all these expenses added together.

Okay, so why do lenders use gross income and not take home pay?

Because there are too many variables to consider. With ‘take home’ pay, one person might have more deductions compared to someone else. Lenders can’t go down the list and verify and validate all your deductions before making a determination of affordability. There can also be areas where there are monthly expenses required where in other areas they are not. 

To make up for these potential discrepancies, lenders simplify matters by using the gross monthly income and not ‘take home’ pay. Yes, there are sometimes requirements for lenders to look at monthly funds available each month after all expenses are accounted for, but these funds, called ‘cash reserves’ aren’t really expenses but ‘set aside’ money lenders like to see after the closing has taken place.

By using gross income, the playing field is essentially leveled so all applicants can be approved using the same basic set of approval guidelines. In this fashion, lenders can evaluate all borrowers equally as it relates to debt ratios.

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David Reed

David Reed (Austin, TX) is the author of Mortgages 101, Mortgage Confidential, Your Successful Career as a Mortgage Broker , The Real Estate Investor's Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. As a Senior Loan Officer and Mortgage Executive he closed more than 2,000 mortgage loans over the course of more than 20 years in commercial and residential mortgage lending. 

He has appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show. His advice has appeared in the New York Times, Parade Magazine, Washington Post and Kiplinger's as well as in newspapers and magazines throughout the country. 

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