When you apply for a mortgage, your loan officer asks a lot of questions about your personal finances. One of those questions will have to do with your annual income. Lenders use this figure to determine how much mortgage you can afford as well as calculate your total debt ratio. Both figures play an important role in whether or not you get approved for a mortgage.
Before we get started, you should know that lenders will likely throw around another word that you should understand – gross annual income. This is different than your net annual income and is the only number you’ll need for lenders.
What is Gross Annual Income?
Your gross annual income is the money you earn before taxes. If your employer pays you a salary, it’s the full amount of that salary. For example, if you were offered $70,000 per year, that is your gross monthly income. We know that you don’t take home $70,000 per year because you have to account for insurance costs, taxes, and other miscellaneous deductions. Lenders care only about your gross income though.
Your gross income, whether annual or monthly, will remain constant. If you make $70,000 a year, that’s what you make no matter what expenses you pay from your paycheck. Your deductions may change from time to time, but your gross income won’t, unless of course, you get a raise.
Figuring Out Your Monthly Gross Income
Your lender may ask you for your gross annual or gross monthly income. You can easily teeter between the two. Your gross annual income, as we discussed above, is the full amount you make for the year. Your gross monthly income is the gross annual income divided by 12.
Lenders use the gross monthly income to figure out how much mortgage you can afford as well as determine your debt ratio. In most cases, you’ll want a housing ratio that is around 28% of your gross monthly income and a total debt ratio that doesn’t exceed 43% of your gross monthly income.
Debt Ratios and Approvals
Your debt ratio lets a lender know how much of your salary is accounted for each month. If you have a 50% debt ratio that means that half of your monthly income is already accounted for with debts. That’s not a position you want to be in, as no lender would give you a loan.
Each loan program has different debt ratio requirements:
- Conventional loans – 28% housing ratio and 36% total debt ratio
- FHA loans – 31% housing ratio and 41% total debt ratio
- VA loans – 43% total debt ratio
- USDA loans – 29% housing ratio and 41% total debt ratio
No matter which loan program you choose, lenders may grant exceptions, but they won’t allow a debt ratio higher than 43%. That’s the maximum allowed before a lender faces consequences should you default on your loan thanks to the new mortgage laws.
Only You Know What you Can Afford
Even though your lender will pre-approve you for a specific loan amount or they may even give you a clear to close on a loan amount doesn’t mean you have to take it. Only you know what you can afford. We suggest that you obtain quotes from lenders and then plug those numbers into your budget. Can you comfortably afford the new mortgage payment? Are you comfortable with the amount of disposable income you have after paying your bills?
It helps to have a dry run. Take the amount of the mortgage out of your checking account and keep it somewhere safe. Now, pay your other regular bills. Are you comfortable with the amount of money that is left or does it make you feel panicked? Is this something you could live with or would it be easier if you had a larger amount of disposable income?
These are the things you need to consider. You don’t have to accept the full amount of the loan that a lender offers. Only accept what you know you can comfortably afford. Remember, you put your home up as collateral. If you become unable to pay your mortgage, you stand to lose your home. That’s why it’s important to understand gross income and debt ratios so that you know exactly what you are getting yourself into before you take out a loan.