When seeking financial backing for a home purchase, one of the first and most crucial steps any buyer should take is to secure pre-approval for a mortgage. After all, you can’t very well buy a house without having the cash to spend.
The process is simple, and like most simple things, it comes with its own hidden pitfalls and a few more risks than meets the eye.
This article will explore the steps, implications, and options surrounding mortgage pre-approval, and leave you with a more comprehensive understanding of what it takes to be a prepared and strategic homebuyer.
What Is Pre-Approval?
Pre-approval is essentially a statement from your lending institution confirming that you are qualified to obtain financing for a real estate purchase, and/or specifying the maximum amount of money that you’d be allowed to borrow.
In a sense, it acts as both an FYI and an IOU –informing the borrower of the limits of their purchasing power when looking to buy a home, and serving as a soft guarantee that said funds will be available when the time comes to close on a deal. The word, “soft”, bears emphasis here, and as we’ll learn later on, mortgage pre-approvals don’t signify any binding obligation on the part of the lender. They are, however, reliable indicators to sellers that a potential buyer is generally good for the required sum.
Pre-Qualification vs Pre-Approval
It’s critical for a buyer to know the distinction between pre-approval and pre-qualification, as it could spell the difference between a successful purchase and a costly mismatch of expectations.
Pre-qualification can be understood as a more cursory go at assessing a buyer’s capacity to borrow. It relies on information supplied to the bank by a buyer (e.g. data on private income, debt, and investments) and results in a ballpark estimate of how much financial assistance the bank can supply in dollar terms. As a process, it’s relatively quick and easy, and yields only a general idea of the size and kind of loan arrangement that can be met between lender and borrower.
Pre-approval, on the other hand, is more thorough in its process and decisive in its outcome. It involves the same broad information used in getting pre-qualified, as well as other documents that will enable the bank to perform a more extensive examination of your financial situation (e.g. your background and credit rating), and a mortgage application which usually comes with a fee. In return, you can expect a more specific (but not necessarily final) number on the potential mortgage and its interest rate.
Why Bother With Pre-approval?
Pre-qualification and pre-approval are tools that give would-be buyers a much needed chance to prepare for the long and weighty affair of purchasing a home. In securing estimates, the buyer has an opportunity to negotiate with the bank, giving them a chance to expand and ultimately settle on a near-final measure of their purchasing power–which will play a crucial role in negotiating with the seller down the line.
And while both pre-qualification and pre-approval are helpful first steps in assessing your ability to buy a house, the latter is necessary in proving it to your potential seller. From the seller’s perspective, pre-approval is a guarantee that all salient features of your financial history have been checked by a competent agent, and gives them greater confidence that the opportunity cost of entering into a deal with you wouldn’t be wasted on a sudden lack of funding and preparation. The amount of research that goes into securing pre-approval serves as assurance that the seller is betting on decent odds by transacting with you.
In short, not only do you need to get around to securing pre-approval, but settling the matter early can actually improve your position as a buyer in a competitive market. If forewarned is indeed forearmed, as the old saying goes, then getting pre-approved is a matter of gearing up for a winning battle on the field of negotiation.
The Steps of Pre-Approval
Getting pre-approved is a fairly simple procedure, and those applying for it can expect to come ready with only five kinds of documentation:
Proof of Income
First, the bank will ask for proof of income from the last two years in the form of W-2 statements, pay stubs detailing both income and year-to-date income, tax returns, and other forms of additional income. This is to give the bank a clear idea of your ability to handle mortgage payments over the life of your loan.
Second, your lender will request bank statements, as well as account statements for your investments to get a sense of your overall wealth and liquidity –which in turn indicates whether or not you have the funds to manage your down payment and other costs associated with the transaction. The amount of cash reserves varies depending on where you source your financing, but you can expect a ceiling of around 5%-20% of the cost of the home.
Third, your bank will have to look into your credit score for the purposes of determining the interest rate on the eventual loan. Naturally, borrowers with higher credit scores (i.e. safer “investments” from the lender’s perspective) can expect lower rates, while those with lower credit scores should expect higher rates or even larger down payments for the relative risk their ratings signify.
Proof of Employment
Next, financial institutions would look for proof of stable employment by calling your most recent long-term employer to verify that you’re still working, and to cross-check your reported salary. It’s during this step that being your own boss poses a bit of an inconvenience, as additional paperwork is required for those who report as being self-employed.
Finally, be prepared with your vital government documents such as your Social Security number, a copy of your driver’s license, and your signature to facilitate other checks and appraisals by the bank.
If the bank finds everything to be in order, you’ll receive a letter of pre-approval good for roughly two to three months (60 to 90 days).
The most important rule of thumb throughout all of this is that efficiency and cooperation are key: being quick and ready to supply the information requested by your lender can significantly expedite the task of securing a mortgage, and signify a committed and professional mindset to your prospective seller.
And since the process is relatively painless, there’s nothing stopping a buyer from making pre-approval their first stop on the road to closing on a house. This ultimately begins the buying process with a greater deal of information about the scope of their financial options.
Turning a Pre-approval Into a Mortgage Commitment
Your newly drafted pre-approval letter should contain terms for its consideration as a commitment to lend. Assuming you manage to keep your finances relatively stable and free of any major negative changes, the following four steps must be completed before you have your bank’s assurance of funding:
Enter into a valid sales contract on a specific property. Naturally, your bank won’t release the loan amount until you’re in business with a seller (or their agent) over a particular piece of real estate.
Your lender will also need to conduct its own appraisal of the property in order to determine if the value of the property is at least close to the price of sale. This might not always be the case, as we’ll discuss in the section entitled, “Failing to Secure a Mortgage after Pre-Approval.”
A mortgage program would also need to be hashed out in order to finalize both the size of the down payment to be made by the buyer, as well as the expected monthly insurance rate as the loan matures.
Finally, the company that conducted the pre-approval would need to issue a rate commitment following the terms set in the foregoing step.
Securing Pre-approval And Dealing With Rejection
Unfortunate though it may be, a poor credit rating significantly dampens your chances of getting pre-approved, and there’s little to be done in the short term to work around this. Maintaining a good credit score is crucial to any major financial decision, and your mortgage is no exception. In the same breath, minimizing your debt and trying to provide as large of a down payment as is feasible can go a long way towards improving your chances of a favorable pre-approval.
These steps are essential to a healthy financial life, and while it’s ideal that proper financial care be a long-standing component of a person’s life plan, having the will to pull out of a disadvantaged position is just as (if not more) commendable.
Getting Rejected Even with Good Credit
It isn’t unheard of for borrowers with decent to above-average credit ratings to be denied. You can do everything right, by all outward appearances, but because of a slim margin from the cutoff or a single blemish on your record, you might find banks and other lenders hesitant to take your side. Thankfully, short-term fixes to these situations tend to be a bit more optimistic.
With a properly-worded letter of appeal, you can have your case sent for a second opinion by another employee at the company from which you are seeking a loan. Alternately, if your request for pre-approval was denied on account of a significant problem in your financial history, a well-documented explanation of the incident and why it shouldn’t be taken into consideration can save you a lot of trouble.
These solutions ultimately bank on evidence: proof that your credit rating should be considered among other, more positive factors reflecting your financial health, or proof that your record would be spotless if not for a financial disaster (not error) that was largely out of your hands. Tie them all together with a professional, authoritative, and well-written letter stating your case, and you may be able to salvage the process.
Failing To Secure A Mortgage After Pre-approval
Mortgage pre-approvals are not mortgage guarantees. The actual mortgage rate can change after you’ve decided on a particular home and the bank has had a shot at appraising it; if the appraised value is lower than the cost, the bank may lower your loan amount to account for the risk in purchasing an overpriced asset.
Worse yet, it’s possible for a bank to reject your loan outright even after pre-approval. The following conditions are common reasons for mortgage denial after pre-approval:
Change in Employment
If your employment changes at any point between pre-approval and final loan application, there’s a chance of rejection. This can be prevented by consulting with the bank during the pre-approval process, and remedied if an appeal is sent in and the bank finds that the switch in employment doesn’t signify a big risk in financial stability. Losing your job, however, usually squashes your chances altogether.
Negative shocks to your credit rating can also lead to rejection. This is easy enough to avoid if your bills are paid on time and you stick to your usual spending.
Another frequently reported cause is incurring additional debt such as loans for college tuition or a new car. This is, again, easy to avoid — simply prioritize your housing purchase and put other large expenses on hold until your mortgage is secured.
Changes to your Bank’s Policies
Finally, on the less forgiving side are changes to your bank’s lending policies which are implemented after pre-approval. These are much harder to resolve as there’s no working around, for instance, a government-imposed shift in minimum credit scores to qualify for loans of a particular size.
The secret to avoiding problems with finalizing your mortgage is to project the image of stability. Avoid large transactions, debt, shocks to your credit rating, and large withdrawals — basically, keep your life running in financial clockwork and assume the position of the lender when assessing your financial decisions. You’re free to make big, responsible financial decisions once the dust settles and everything is set in stone (or writing, as it were), but no sooner.
Shopping Around for Mortgages
You aren’t bound to stick with the first financial institution you ask for pre-approval. You’d be well within your rights to survey as many mortgage vendors as you please to see if other lenders can offer you better rates and accept those offers should you so decide. If you can afford the application fee, there’s no shame in looking for the best deal out there, and the government recognizes your right to take full charge of your finances.
Contrary to popular belief, your credit rating only takes a minimal and necessary hit the moment you apply for a credit check and your bank performs an inquiry, and anyone who’s ever pulled a loan –from CEOs to the average Joe — has absorbed the penalty. Subsequent inquiries within a 45-day period have no bearing on your credit score (they’re counted as a single inquiry), so scan the market to your heart’s delight.
It pays to prepare a list of potential lenders before applying for pre-approval, since a 45-day period can pass in a minute for buyers who lead busy lives and have only just enough time to spare on purchasing a new home.
This is also a preferred option among those who, as mentioned earlier, fail to secure pre-approval on their first try with a lender. You’re free to pack up and try again with a new one, if you’re absolutely certain the problem isn’t you or your credit score.
Most of the suggestions we have on navigating pre-approval have been covered: be prompt, be professional, and keep your finances in order. There does remain one bit of advice that could make the process much more pleasant: be empathetic. No matter if things are going well or poorly for your attempts at pre-approval, take a step back and analyze the situation from the perspective of a lender, as this can give you valuable insight moving forward.
For example, a large source of unnecessary stress for many borrowers is the frustration that comes with an inability to see the value in the process they have to undergo. Things are much more pleasant and easier to digest when one considers that lenders are in a risky position: they have to do their part to assess the likelihood of payment default in order to keep their business running.
Beyond this, one can only truly claim to know what it takes to achieve good credit if they can see things from the point of view of a financier. It’s one thing to know that timely payments and well-spaced entries into debt lead to good credit, and another thing entirely to understand why these things play out the way they do. Perhaps one could stick to a routine; but with the latter, it becomes much easier to visualize the consequences of potentially damaging financial choices and avoid them.
A comprehensive understanding is the key to a great strategy. Maximize your perspective to make the most out of the information that’s out there — and when in doubt, ALWAYS have the sense to ask about what you don’t already know.