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Whenever I see someone ask how to calculate how big a mortgage he can afford, the answer almost always comes back as a percentage of gross income.

Why use gross income as the baseline? Why not net income?

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5 Answers

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You can choose to pay your mortgage instead of another bill, or vice versa. Your net will change from month to month while your gross is relatively static.

I can make a bunch of promises to my load officer about my expenses, but it is very difficult to verify. Moreover, it is pretty hard to give your net income and plan for emergencies.

So for the sake of reliability, verifiability, and general ease a lender will look at your gross.

YOU should definitely look at your net when deciding if you can afford a loan.

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The percentage of gross income is a quick and easy way to arrive at the rough ballpark figure of the mortgage one can afford.

The net income is something which one does not know offhand.

If you want to seriously evaluate then most of the standard mortgage calculators will ask you to enter your gross income, your other liabilities like Auto Loan, Student Loan, personal Loan, Card Payments, Any other regular payments like Child Support etc.

After factoring all these one arrives at the actual mortgage one can afford.

As is evident, the above requires a good amount of calculation and hence the preffered method becomes on the basis of gross income.

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"The net income is something which one does not know offhand." Unfortunate, but true. –  kajaco Oct 7 '10 at 16:03
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People typically present themselves to be as wealthy as possible to banks and as poor as possible to the government at tax time.

Gross income is really the most reliable number for most folks. Your and your employer are required by law to report an accurate gross income figure annually. Anything else is totally situational.

All they are doing anyway is computing your total debt-to-income ratio and mortgage-to-income ratio. The government agencies that buy mortgages, the big bank that buys the mortgage or the self-underwriting bank has differing standards for different products.

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Cynical answer:

Real Estate agents make money on commission from sale of houses, so their compensation is tied to the home price.

Banks make money off loans, so it is in their interest to make larger loans (as long as the loan gets paid). So their is a tension at the bank between selling a larger mortgage, and ensuring that their customer can pay the mortgage.

Gross income is easier to check, and the taxes at a given income are fairly predictable. And banks realized that people can change their medical and retirement deductions.

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Gross income is used because there are a lot of variables inherent in the calculation of a "net income", including a lot of things under your direct control that you could use to game the system.

"Net Income", as others have inferred, is a very flexible term. For the average individual, the definition that would most easily come to mind is likely post-deduction, post-tax earnings; "take-home pay". It sounds reasonable, too, as the amount you take home each month can be easily demonstrated with your two most recent pay stubs (which you need to bring in anyway to verify gross earnings). However, even that simplistic definition is fraught with possibility. You have the ability to modify your pre-tax deductions, such as for retirement or healthcare, and that in turn affects your taxes and thus your net take-home pay. To assume that you won't do that is foolish for the loan officer.

Other definitions of "net income", such as, in the case of shopping for a house, "disposable income plus current rent", are the result of even longer lists of deductions from gross pay. Many are also dependent on your current home; your electric bill is a function of the size, location and construction of your current home, all of which will change as soon as you move in. Your other bills, such as telecom (TV/phone/internet) are also more or less location-dependent, as even within a single city or metro area, your choice of services and service providers is dictated by the home's physical location. You may have to pay through the nose right now because your current home isn't serviced by anyone's fiber-optic network, while the home you're moving into could be in a hotly-contested area with access to multiple fiber-optic trunks.

So, to simplify all this, mortgage companies simply ask for gross income, then apply a metric that makes relatively conservative assumptions about your spending habits to arrive at a final amount. The upside is simplicity, the downside being that two people both making $60,000/yr may have two completely different financial pictures behind that single number.

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