The current practice of lending based solely on gross income without considering a borrower’s expenses can be flawed for several reasons, particularly in today’s economy:
Cost of Living Disparities: Gross income does not account for variations in the cost of living across different regions or individual circumstances. A borrower with a high gross income in a high-cost area may have significantly less disposable income after covering essential expenses compared to a borrower with a lower gross income in a more affordable area.
Debt-to-Income Ratio Misrepresentation: Focusing solely on gross income when calculating debt-to-income (DTI) ratios can lead to misrepresentation of a borrower’s true financial situation. A borrower with high expenses relative to their gross income may appear less risky than they actually are, potentially leading to overextension and default.
Inflation and Cost of Living Increases: Over time, inflation and increases in the cost of living can erode the purchasing power of gross income, making it increasingly challenging for borrowers to meet their financial obligations. Ignoring these factors when assessing a borrower’s ability to repay a loan can lead to loans being approved that borrowers may struggle to repay in the future.
Economic Volatility and Uncertainty: Economic downturns, job losses, and unexpected expenses can significantly impact a borrower’s ability to repay a loan, regardless of their gross income. Focusing solely on income without considering a borrower’s overall financial stability and resilience to economic shocks can increase the risk of default during times of economic uncertainty.
Regarding the perception that non-W2 workers are higher risk than W2 workers, it’s essential to recognize that both types of employment arrangements come with their own set of risks and challenges:
Income Stability: W2 workers typically have a stable and predictable income stream, which may make them appear less risky to lenders. However, they may also be more vulnerable to job loss or income reduction in the event of layoffs, company downsizing, or economic downturns.
Income Variability: Non-W2 workers, such as freelancers, contractors, and self-employed individuals, often have variable income streams that can fluctuate from month to month or year to year. While this may present challenges in income verification and budgeting, it can also indicate entrepreneurial drive and adaptability.
Documentation Challenges: Non-W2 workers may face additional challenges in providing documentation to verify their income and financial stability, as traditional lenders often require W2 forms or tax returns as proof of income. This can make it harder for non-W2 workers to qualify for loans, even if they have sufficient income to repay them.
In summary, relying solely on gross income without considering a borrower’s expenses and overall financial stability can be flawed in today’s economy, where cost of living disparities, economic volatility, and job market uncertainties are prevalent. Both W2 and non-W2 workers come with their own set of risks and challenges, and lenders should consider a borrower’s entire financial profile when making lending decisions to ensure responsible lending practices and minimize the risk of default.