Credit scores are great for determining how you've handled your debt payments in the past, but even a perfect score doesn't mean you have loan repayment superpowers. Before trusting you with their money, lenders want to know that you have the financial means to repay the loan. Since your credit score doesn't consider your income, lenders need to get it from somewhere else.
Why Lenders Use AGI
Even though you might be perfectly honest if asked how much you make, lenders don't believe that everyone will tell them their correct income. However, given the penalties that apply for misreporting income to the IRS, lenders generally accept your tax returns as an accurate statement of your income. When you supply lenders with a copy of your tax returns from the past couple years, lenders can also see how stable your income is and where it comes from. For example, a borrower with a stable job is usually a lower default risk than a borrower who is paid on commission and whose income varies wildly from year to year.
Significance of Income
Lenders typically use your pretax income to figure the maximum you can repay each month for mortgage expenses. Some may use an adjusted figure depending on your adjusted gross income, or AGI, because your AGI represents your total taxable income minus certain adjustments, such as student loan interest. Typically, lenders use about 28 percent of your monthly income as the amount that you can afford to pay for your mortgage. Lenders also generally cap your total debt payments at 36 percent of AGI. Your total debt payments include not only your mortgage, but any other debt such as personal loans, student loans or car loans.
Adjustments to Your AGI
Lenders recognize that different people may have higher or lower AGIs than is actually representative of their ability to repay a loan. For example, if you moved last year across the country to take a promotion that will pay you a larger salary, you likely deducted your moving expenses, which would lower your AGI. However, that's likely a one-time expense that the lender will know will not be affecting your ability to repay in future years. Conversely, if you had a larger AGI because you sold off many of your investments in the last year, the lender would anticipate you having a lower AGI in future years.
Lost or Missing Tax Returns
The IRS makes it easy to request a transcript of your prior year's returns, so even if you didn't make a copy or lost it, the information can still be obtained by requesting a transcript from the IRS. A tax return transcript shows line-by-line entries that you made on your tax return, which is usually acceptable to lenders. You can request a transcript with Form 4506T-EZ, Short Form Request for Individual Tax Return Transcript, and even have the transcript sent directly to the lender.
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