Gross Income and Getting a Mortgage

You’ve likely heard the term “gross income,” but maybe you’re not really sure what it means and you’ve just nodded along, figuring you likely have the general idea. Gross income is actually a specific term, and it has a strong impact on your ability to purchase a home.

What Is Gross Income?

Gross income equals the total amount of earnings a person, or business, makes before subtracting taxes and other expenses. For businesses, gross income may be called “gross margin” or “gross profit.”

Gross income is typically your annual salary, and thus the starting point when you file your tax returns because it determines your federal income tax bracket.

Gross Income Vs. Net Income

You may often hear gross income used in conjunction with “net income.” Here’s the difference: Gross income is the total of your income, while net income is what you’re left with after all the deductions are taken out. These deductions include:

• Income and Social Security tax
• Health insurance and health savings account (HSA) contributions
• IRA, 401(k) or retirement fund contributions
• Any necessary legal payments, such as alimony or child support

Here’s a simple way to remember the definition: think of net income as what’s in your “net.” In other words, it’s what you take home with you from your job, which is also why it’s sometimes called “take home pay.”

Mortgage lenders often look at gross monthly income to determine how much mortgage you can afford, but it’s also important to consider your net income, as well.

How To Calculate Gross Monthly Income

Calculating your gross income is simple: total up all your income sources before taxes or other payroll deductions. For instance, imagine you have an annual salary of $80,000.

In addition to that figure, let’s say you made $2,000 doing freelance work and $500 from selling items online. Calculating your annual gross salary would look like this:

• $80,000 + $2,000 + $500 = $82,500

Therefore, your gross monthly income would be $82,500/12 (months in a year) = $6,875.

Other figures to consider when making this calculation would include:

• Tips from your place of employment
• Items sold online, or at a fair or other venue (even as a hobby)
• Rental income
• Unemployment earnings
• Capital gains from investments
• Alimony payments
• Pension payments

When you calculate these numbers, you can use this to help determine a house budget. To do this, determine your gross monthly income and then compare it to your monthly costs, which include house payments or rent, car payments, groceries, student loans, entertainment and other costs. 

Gross Income Vs. Adjusted Gross Income (AGI)

When lenders look at your financial situation, they will often calculate your adjusted gross income (AGI), which determine the amount of your income that is taxable. Your AGI is your gross income minus IRS calculations — or “tax deductions.”

Some common tax deductions include:

• Moving expenses due to job, business or military relocation 
• Student loan interest or tuition fees
• Alimony payments
• Self-employed expenses
• Charitable donations

Itemizing your deductions will lower your AGI, which lowers your taxable income. Accurately reporting your AGI on the IRS Form 1040 determines your eligibility for claims on your tax return. The more claims you’re eligible for, the more money may receive on your return.

Figuring out which deductions you qualify for can be tricky, so it’s best to consult with a tax expert or CPA to ensure you’re earning the highest tax benefit possible.

Adjusted Gross Income Vs. Modified Adjusted Gross Income (MAGI)

If you’re looking to obtain a mortgage, you should first determine the amount of monthly payment you can afford — which means it’s critical to have a strong knowledge of your financial situation. Beyond your AGI, you should know your modified adjusted gross income, also known as MAGI. To calculate your MAGI, take your AGI and add back the following deductions:

• Specific tax exemptions (homestead, disability, senior or veteran)
• Retirement fund and Social Security contributions
• Student loan interest or tuition
• Excluded foreign income
• Rental and other passive income or losses

Your MAGI determines the following:

• Whether you can contribute to a Roth IRA 
• Whether you can deduct your regular IRA contributions from your taxes
• Your eligibility for the premium tax credit

It’s normal for your AGI and MAGI to be close in amount. While you can always contribute to a traditional IRA, you won’t be able to deduct these contributions on your taxes if your MAGI exceeds the IRS’ limits.

Why Gross Income Matters: The 28/36 Rule

There is a shorthand calculation that can people you determine how much of a mortgage you can afford: The often-referenced 28% rule says that you shouldn’t spend more than that percentage of your monthly gross income on your mortgage payment, including property taxes and insurance. This 28% is often referred to as a safe mortgage-to-income ratio, or a good general guideline for mortgage payments.

The 28% rule is fairly easy to figure out. Let’s say your household brings in a total of $6,000 every month in gross income. Multiply your monthly gross income by .28 to get a rough estimate of how much you can afford to spend a month on your mortgage. In this example, you shouldn’t spend more than $1,680 on your monthly mortgage payment if you’re following the 28% rule.

Homeowners often use the 28% rule because it strikes a good balance between buying the home they want and keeping money in their budget for emergencies and other expenses. However, it’s important to remember that you don’t need to spend up to your monthly limit. Think of 28% as the ideal amount you should spend monthly on your total mortgage payment. Remember to include your principal, interest, taxes, insurance and (if applicable) homeowners association (HOA) dues in your total before you take out a home loan.

28/36 Rule

There’s a follow-up to this specific equation that recommends you shouldn’t spend more than 36% on all your other debt (house debt, car loans, credit cards, etc.). This is another good guideline to use if you’re trying to determine how much you can afford without stretching your budget.

A good place to start is with the Quicken Loans® mortgage affordability calculator, which can help you calculate your monthly debt. The calculator requires you to input elements including your annual income, monthly obligations, your credit rating and other variables. With this information, Quicken Loans can provide an estimated range for your monthly mortgage payments.

The Bottom Line

When you’re ready to buy a home, knowing more about mortgage requirements can only help you prepare for the process. So, it’s critical to know how much money you can spend, and knowing your potential monthly mortgage payment can help as you move forward into this complicated realm.

Calculating your gross monthly income can give you a realistic perspective on your economic situation, but getting initial approval for a mortgage can also help you find out more about what kind of mortgage loan you can qualify for based on your income.