Should I Use Net Income or Gross Income for Tenant Screening?
It’s common knowledge that as a landlord, you should invest in screening your tenants. One bad tenant can cause a series of headaches, late rent payments, and possibly the expense and hassle of an eviction process costing $3500 or more. Ugh!
One goal of tenant screening is to get comfortable with an applicant’s capacity to pay rent over the long haul. What signs raise red flags? There are indicators to improve predictability.
Income verification is the most direct indicator of whether rent will be paid on a monthly basis, and it offers the most current information to help you build a financial profile of your tenant applicant, especially when the income info is independently confirmed.
An applicant’s lack of funds is the number one reason for eviction
Many potential tenants overestimate how much they can afford. A classic example is when an applicant declares they make $75,000 a year, but after taxes, insurance, 401k contributions, and other deductions, the net amount they take home is a lot less than what they reported in an application. Their gross income illustrates their earning capacity, yet does not reflect their ability to manage ongoing obligations.
It’s unlikely most renters are inflating their reported income – they just don’t consider all the reductions to their gross pay. You, as a responsible landlord, need to verify the applicant’s capacity to pay rent. The best bet is to understand the applicant’s net income, their true spending power.
To help illustrate the point, let’s do some quick math. An applicant could have $12,000 monthly gross income and wants to rent a $4,000/month apartment. If you see their self-reported income of $12,000, you might think there’s enough income to cover rent obligations.
What if the gross income was reduced by 25% for federal income tax and 6-7% for state income tax? You now have a monthly income of ~$8,400 or barely 2x rent. Now, if they have retirement deductions coming out of their paycheck, you’d never know it. Maybe they are socking away $1,400 per month to retirement? Now, you’re looking at $7,000 per month, which is $5,000 less than what they self-reported, and 1.7x their monthly rent. You have no visibility into these actualities unless or until you look at net income.
5 ways to verify your applicant’s net income
1. The Closing Docs Income Report
The easiest way to calculate your applicant’s net income is to use the automated income verification report from The Closing Docs. The report calculates an applicant’s annual net income, monthly net income, and includes any one-time deposits like bonuses or commission-based salaries for the past year automatically. And it’s free for the landlord!
2. Bank Statements
The next best thing to verify your applicant’s net income is analyzing their bank statements. Your applicant’s bank statements will reveal inflows and outflows. However, you are left culling through extraneous information as you deal with finding what’s relevant. Once you identify deposits, then you need to take the time to calculate monthly net income. Cumbersome.
3. W-2 Income Statements
The W-2 income statement illustrates reported income for tax filing purposes. This document is reliable and produced by the employer – but only includes the applicant’s gross income and their taxes paid. It does not show any contributions to retirement, HSA, or other deductions their employer might have. This data offers limited usefulness to the landlord wanting spending power predictability.
Many applicants will not have their W-2 readily available. Additionally, the W-2 does not account for any raises or give the most up-to-date picture of the applicant’s financial situation.
4. Pay Stubs
If your applicant has an employer, they will generally receive a pay stub document from their employer. A pay stub will show the applicant gross income and net income. They are usually easy to find for your applicant, but also easily forged. A simple search on Google will show hundreds of pay stub templates to choose from.
If you choose to verify income through pay stubs, it is prudent to also verify their employment directly by calling their employer’s HR department.
5. Offer Letter From Employer
Another easy one to get if your applicant has an employer. This is a document of your applicant’s initial offer letter when they first received their job. While an offer letter provides the gross income of the applicant, it gives no other details about the deductions made before the money hits the bank account.
An offer letter can also be easily faked. Simply opening a Word document and adding a company logo can do the trick. Be sure to call the company’s HR department and verify their employment.
The widely accepted standard to financially qualify an applicant is to calculate the rent-to-income ratio of your applicants. The total household net income should be 2.5x the monthly rent of the unit.
For example, if the monthly rent is $1,000, then the household’s verified net income should be at least $2,500 to qualify as a stable tenant.
If you use The Closing Docs to verify your applicant’s net income, the data is independently confirmed, calculations are performed and then presented in an easy to use, easy to understand format. The individual report also includes a recommendation on whether to approve or decline the applicant. The process also accommodates roommates and shared bank accounts.
One of the toughest things about being a good landlord is finding and keeping good, quality tenants. This article demonstrates there are several approaches, and shows the value in considering an applicant’s net income instead of gross income.
While some applicants deliberately forge income documents in order to get approved, others over-inflate their gross pay as an honest mistake. Either scenario could leave a landlord in the lurch. Difficult situations can be avoided by employing a thorough, independent analysis of an applicant’s net income.
High quality income screening as a part of your approval process will increase the accuracy and confidence you’ll have in the people you are considering as candidates. Taking the time to do it right saves both time and money. Use automated income verification.