In the market to purchase a house? Understanding the definition of gross income can help you not only be better prepared for the mortgage process, but also know how much home you can afford before you begin looking. But what, exactly, is your "gross" income?
Gross Means “Before Taxes”
The term “gross” refers to your total personal income before taking taxes or deductions into account. Let’s say you earn $3,000 per month for a yearly amount of $36,000. That’s your gross income. After your employer takes out Social Security taxes, Medicare, income tax, health insurance, retirement and so on, what you’re left with is your take-home pay, or net income.
Can You Afford A House Payment?
When you apply for a home loan, the lender needs to make sure you have enough available income each month to make the mortgage payment. To do that, it starts with your gross income. From that, it subtracts all of your current debt obligations. The goal is to have your total debt payments each month fall below 36 percent of your gross income, the industry standard for debt.
Going back to the $3,000 per month example, let’s say you have credit card payments totaling $400 a month, an auto loan for $300 a month and student loans totaling $200 a month. Add them up and you're paying a total of $900 each month toward debt. Thirty-six percent of $3,000 is $1,080. So in this example, the $900 you're paying toward debt each month is below 36 percent, meaning your current debt load is not too high to preclude the addition of a house payment.
The Magic Number: 28
As a standard industry guideline, your monthly mortgage payment — which includes principal, interest and in some cases property taxes — should not exceed 28 percent of your gross monthly income. To see if you meet the 28 percent or less criteria, simply multiply your annual salary by 0.28, then divide that number by 12.
$36,000 x 0.28 = $10,080
$10,080 divided by 12 = $840
Using this formula, $840 would be the maximum amount you would be able to spend for housing each month — which means the lender wouldn’t approve a home mortgage that called for monthly payments higher than $840.
Several additional variables -- including credit history, credit score, employment history and the size of your down payment -- are important considerations as you prepare to apply for a home loan. Beyond the monthly payments on credit card balances, a car loan and student loans, you must also factor in the average costs of basic utilities, cable and Internet, groceries, entertainment, clothing and car fuel, as well as premiums on insurance policies.
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