Once you have made the decision that homeownership is right for you, you may feel inclined to rush out and start your search for the perfect home right away. But mortgage experts advise a different approach. You may be better off to get pre-approved for a mortgage loan before home shopping.
Think of it as checking your wallet before you head to the store. It may not be absolutely necessary, but it does give you confidence when you are walking through those grocery aisles, right? And, it could save you some potential embarrassment at the check-out too.
What is a mortgage pre-approval?
When you are pre-approved for a mortgage, your bank, credit union, or mortgage company has looked at your financials and your credit score and has made a determination about how much they are willing to offer you in the way of financing for a home purchase or refinance. It is not a legally binding contract. Rather, it is a letter that states how much money they would lend you for a mortgage.
It does not guarantee that you will get a specific loan, but it is a great first step in your home buying journey.
What is the difference between pre-qualification and a pre-approval?
A mortgage pre-qualification is a simple, straightforward process in which you talk with a lender about your income, your assets, and your debt load. The lender will then give you a ballpark figure of how much of a home loan you will probably be able to afford based on the information you have provided. In essence, a pre-qualification is little more than a “guesstimate” on the part of your lender.
This estimate is useful in helping you figure out if buying a home is a viable option, and if so, what your price range would probably be. It requires no commitment from either you or the lender. Therefore, it is simply used as a guideline for approximating how much house you can afford.
A pre-approval, on the other hand, carries considerably more weight. It involves providing documentation to your lender to confirm your income and debt. It also means your lender or mortgage broker will check your credit report. If your creditworthiness and income-to-date ratios pan out, your lender will issue a pre-approval letter.
Does a pre-approval guarantee you will get a loan from a lender?
It is important to remember that a pre-approval letter does not constitute a guarantee that you will get a mortgage loan. It does, however, give you a good idea how much you are likely to get when you apply for real.
However, that amount can change based on many factors. For instance, regardless of your creditworthiness, the home you choose will need to meet the lender’s requirements. Hypothetically, your lender could refuse a loan application if the home you are trying to purchase appraises for much less than the asking price or if a title search of the property reveals an ownership issue.
The pre-approval, then, is a tentative commitment on the part of your lender. Neither you nor your lender has to honor the terms of the pre-approval letter.
What are the advantages of a mortgage pre-approval?
Even though your pre-approval letter is not a guarantee of getting your mortgage loan, it is still valuable for several reasons. First, it gives you a solid understanding of what you can afford in the way of housing. It also saves you considerable time in the home searching process.
Pre-approval potentially saves you some disappointment as well. No one enjoys finding a home that seems just perfect, only to find out that it is out of range price-wise. Having solid information about what you can afford from the get-go will help you avoid that unpleasantness.
Second, a pre-approval letter in your hands lets realtors and sellers know that you are serious about buying. In highly competitive housing markets, a pre-approval letter may be the factor that causes a seller to accept your offer over someone else’s.
Third, a pre-approval letter gives you the confidence to negotiate aggressively. If you know how much you can likely get in funding, you can negotiate a reasonable offer quickly. If you find a motivated seller and have a pre-approval letter in your hand, you are well on your way to closing on a home loan.
What are some things that might make it hard to get a pre-approval?
The most common reason for not getting pre-approved for a mortgage loan is bad credit. Currently, the average purchase home loan is $296,600 (source). It is easy to understand why lenders would be unwilling to lend such a significant amount to a buyer who has not demonstrated creditworthiness.
Lenders have different credit score requirements depending on the type of mortgage loan for which you are trying to get approval. For instance, FHA loans are not available to borrowers with credit scores below 500, but with a credit score of 580 and above, you may be eligible for maximum FHA financing (source).
The higher your credit score, the more likely you are to get a pre-approval. If you have a low credit score, it may be best to work on repairing your credit before trying to purchase a home.
Another issue could be your debt-to-income ratio. Lenders want to know that you can afford your monthly mortgage payment. If your debt-to-income ratio is too high, consider paying off some of your debt before purchasing a home.
If your proposed down payment is too low, lenders will balk at giving you a pre-approval letter. You can eliminate this problem by saving up more of a down payment before you begin the process.
Another issue that may prevent you from getting a pre-approval letter is an unstable work history. Typically, lenders want you to stay put at a job for a couple of years before purchasing a home. A stable work history reassures lenders that you are financially responsible and able to pay your future mortgage payment.
What information will you need to gather to get a pre-approval?
To make the pre-approval process go smoothly, you will need to collect some information and documentation. First, it is a good idea to check your credit score. This will alert you to any problems that might impact your ability to purchase a home. If you find problems, you can take steps to repair your credit before moving forward with the pre-approval process.
Once your credit scores are in shape, then you can begin your search for a lender or mortgage company. Many home buyers prefer to work with mortgage companies because mortgage companies work with a large variety of lenders and loan products, giving home buyers more choices for financing.
At a minimum, your lender or broker will want the following documents to verify your information:
Proof of income
Your lender will need some proof that your income is what you say it is. To prove your income, your lender may ask for the last two tax returns you have filed, W2s from the past two years, your two most recent pay stubs, and proof of any other income you include such as alimony or bonuses.
Proof of assets
To give you a pre-approval letter, your lender will also need to see that you can afford to pay the down payment, closing costs, and any other expenses involved in purchasing a home. To prove this, you will need to provide bank statements and investment statements, if applicable.
Note: If part of your down payment is from a family member or friend, your lender will require your relative or friend to provide a gift letter stating that the money is a gift instead of a loan.
You will also need to give your lender permission to pull your credit report. A good credit score is important if you want to get the best rates and terms for your mortgage loan.
In addition to reviewing your paystubs, your lender will likely call your current employer to verify your employment. If you have recently changed jobs, your lender will call your current employer and your previous employer. Why? The simple reason is that lenders are hesitant to loan money to anyone with a poor job history because the lender depends on income from your job to help you pay your monthly payments.
Identification Documentation: Your lender will also require a copy of your social security card and at least one form of official ID with your picture on it. Typically, a driver’s license or state-issued ID will suffice.
How can self-employed individuals get a mortgage pre-approval?
It is possible to get a mortgage pre-approval if you are self-employed, but prepare to jump through a few more hoops to do it. Typically, you will need to have at least two years of self-employment before you even begin the house hunting process.
Your lender will want to see your personal returns, your business returns, and profit and loss statements from your business. Lenders look at the growth pattern for your business as part of their criteria for offering you a loan. So, it is important to show year-over-year growth by providing supporting documentation for several consecutive years.
Lenders also figure your income differently when you are self-employed. For instance, they will likely take at least the last two years of your business tax returns and average them to come up with an average income amount to use in any debt-to-income ratios.
Be ready to provide supporting documentation for everything about your business income and sweeten the pot as much as possible by increasing the amount you are willing to use for a down payment.
What monthly costs can you expect when owning a home?
Even with a pre-approval in your hand, it is important to consider all the costs associated with purchasing a home. Here are some of the items which may be part of your mortgage payment:
- Repayment on the amount your borrow, also known as the principal.
- Interest on the principal.
- Private Mortgage Insurance, if your down payment is less than 20 percent of your loan-to-value.
- Property taxes.
- Homeowner’s insurance.
- Understanding all the costs related to mortgage loans will help you decide if and when it is a good idea for you to purchase a home.
Where can you find a mortgage company?
When you are ready to move forward with finding a home, consider the significant benefits of getting a pre-approval first. A good mortgage company can help you through the pre-approval process and make it easier for you to get a loan when you are ready. To get started, you can find the best mortgage companies here.