When you’re ready to buy a house, a mortgage pre-approval is a smart step to take. Whether it’s your very first house or just your next one, mortgage pre-approval will ease your stress and save you a bunch of time. After going through the pre-approval process, you’ll have a much clearer idea about your overall house-hunting budget. You’ll also be able to see how your monthly mortgage payments sync up with the rest of your budget. Plus it may give you the upper hand in those high-pressured real estate bidding wars that seem more and more common.
This article will educated you about the mortgage pre-approval process — what it is and why it’s important, plus how to go about getting your own pre-approval. Happy house shopping!
What is a Mortgage Pre-Approval?
The best way to describe the mortgage pre-approval process is in medical terms. Consider it the “annual physical” of your finances. It’s an in-depth, complete examination of everything related to you and your money. It includes your income sources, outstanding debts, savings, valuable assets, financial obligations, credit history and score, and even your employment history.
Potential mortgage lenders want to know every little detail before they commit to lending you hundreds of thousands of dollars. You can’t really blame them. Once they have all the information, lenders will be able to tell you how much of a mortgage they are willing to offer you.
What You Will Need
As a bare minimum, you will probably need the following documentation in order to get pre-approved for a mortgage. Your potential lender may ask for additional information too. Here are some of the items you will most likely be asked to submit in order to receive a mortgage pre-approval.
- Two or Three years of tax returns. Maybe more if you are self-employed.
- A letter from your employer, confirming your income and status as an employee.
- Recent pay stubs (typically the two most recent stubs will suffice).
- Driver’s license or passport.
- Current statements from any credit card or lines of credit you may have.
- Up-to-date information on any other loans (personal, auto, business).
- Current statements on any savings or investments you own (bank accounts, mutual funds, real estate, etc).
- A court order indicating spousal or child support obligations (if applicable).
- A gift letter, if a relative is offering you money as a down payment.
Like we said, this is a serious financial examination. Lenders will try to leave no stone unturned in their attempt to vet you.
A Note About Gift Letters
Here’s an important point related to a gift letters. If you have an existing line of credit shared with another person (who is not applying for this pre-approval), it may or may not actually reflect your ability to repay the loan. You can submit a letter which documents your lack of responsibility for repaying the debt in question. For example, if you co-signed another person’s student loans but that person has paid the previous 12 months without your help, the lender may waive this loan from your financial picture.
Pre-Approved or Pre-Qualified?
While these two terms sound the same, they actually mean quite different things. So don’t make the mistake of confusing them.
A pre-qualification involves a lender gathering a significant amount of your financial information and offering you an estimated loan amount. In short, it’s not binding or set in stone in any way. A very crude way of putting it is that the lender basically filled out a mortgage calculator on your behalf. It’s nothing more than that.
A home seller may not accept your offer from you if you only have a pre-qualification letter — especially if another offer comes from someone with a pre-approval letter, vouching for their ability to secure adequate financing to purchase the home. Sellers want certainty that the person they choose to sell their home to can actually receive a loan and close the transaction.
A pre-approval, on the other hand, is the real deal. It involves filling out a mortgage application and the lender pulling your credit report. It’s a hard credit check, which may temporarily cause your credit score to drop slightly. The advantage is that you can literally use this pre-approval to make an offer on a house. If you’re pre-approved for $500,000, you can make an official offer for a house that costs $450,000 without it being contingent on securing financing.
As stated in the section above about a mortgage pre-qualification letter, securing a mortgage pre-approval letter might make your offer more attractive to the sellers, especially when compared to another potential buyer who does not have a pre-approval letter.
How Soon Is Too Soon?
Buying a house can be a lengthy process. Between the pre-approvals, shopping around, making offers (and counter-offers), dealing with real estate agents and lawyers, it could take you months from the time you decide to buy a house and the time you put your new key in the front door for the first time.
However, most mortgage pre-approvals are only good for 60 or 90-days. Occasionally you will find some lenders willing to honor a pre-approval for 120 days. If you don’t complete the purchase of a house in that time frame, you’ll have to re-submit new copies of all those documents you already submitted. It could for you or against you. For example, if you cleared out some debt in the last couple months, maybe you’ll be eligible for a larger mortgage. On the other hand, interest rates may have shifted in a direction that will cost you more.
The short answer is this: don’t bother with a pre-approval until you’re very serious about making an offer. You may not know the exact house, yet. But you’ll know roughly what price range and location you’re interested in. Then, when you do find “the one,” you’ll be ready to strike quickly. Hopefully that pre-approval letter helps seal the deal.
You Don’t Have To Take It All
Here’s a tip that the lender probably won’t tell you. You don’t have to use every dollar they offer you. Sure, they crunched the numbers and came up with an amount that they are confident you can pay. However, that doesn’t mean the amount won’t leave you overextended or cash poor. Do you really want to live in a reality where you can only afford your home if you drive a 15-year-old car, eat Ramen noodles four times a week, and never take a vacation? Maybe that works for you. But maybe it shouldn’t.
Just because your lender pre-approves you for $750,000 doesn’t mean you can’t look at houses in the $650,00 range. In fact, we recommend that you do. It’s perfectly okay — advisable, even — to not use every bit of your pre-approval amount. As an added bonus, your down payment will now go a bit farther and your monthly payments will be a bit lower. Use those savings to invest more or pay down other debt. Or, you know, to buy a car that was built this decade.
The Process
Once you’ve gathered all the required information, you’ll need to fill out a mortgage application. If you’re co-applying (with a spouse, for example), you will both need to provide your financial documents. Then you’ll need to determine the following things.
- Type of Mortgage and Terms – Which mortgage product you’re applying for, the loan amount, and terms (like amortization period and interest rate).
- Property Information – You’ll need to provide the address and legal description of the building (i.e., free-hold single family dwelling). You will also need to indicate whether the loan is to purchase, refinance, or build new construction.
Those items, along with your personal, employment, and financial information, will determine the success or failure of your mortgage application.
Some Other Factors
We’ve already mentioned your credit history, credit score, and employment history as relevant information. Here are two other values that you need to be aware of.
Debt-to-Income Ratio
Your debt-to-income ratio (DTI) is a calculation of all of your monthly debt obligations in relation to how much money you make. It will factor in auto loans, student debt, revolving credit (like a credit card or line of credit), or any other obligations you have. Child or spousal support may also factor in here. Lenders will divide the sum of these debts by your gross monthly income.
If your DTI is higher than 43%, you may not qualify for a mortgage at all. You are at a higher risk of defaulting on your mortgage if your DTI is too high. Ideally, your DTI will be under 30%. That shows lenders that you have been responsible with previous debts. This value is why financial experts constantly recommend you pay down as much debt as you can before applying for a mortgage.
Loan-to-Value Ratio
The loan-to-value ratio (LTV) is another important calculation. It’s determined by dividing the amount of your loan by the value of the property you are buying with it. It may require a professional appraisal. A high LTV implies you are using more financing to purchase a home as opposed to placing a bigger down payment on the property, resulting in more equity in the property. Your down payment as a percentage of the home’s value is the single biggest factor in what your LTV ends up being.
The lender wants you to have some of your own investment in this game. It helps ensure you won’t walk away from your mortgage if times get tough. The higher your down payment, the more immediate investment you’ve instantly made in your property. Here’s some quick examples:
- You buy a $500,000 house, but only have $50,000 as a down payment. That’s only 10%. You will probably be required to buy private mortgage insurance (as added cost). Your LTV ratio is also quite high, since you still owe almost the entire value of the house over the lifetime of the mortgage.
- You buy the same $500,000 house, but with a $125,000 down payment. That’s 25% of the total cost. Your mortgage payments will be lower, you won’t have to get mortgage insurance, and your LTV rate is much lower. That may qualify you for even lower mortgage rates. As an added bonus, you immediately have a large chunk of equity in your house, should you ever need to refinance.
Shop Around
Like any other product you buy (and a mortgage is definitely a product that you buy), you should shop around. Seek pre-approvals from a few different lenders. They may come back with slightly different amounts or interest rates. Don’t be afraid to use those differences to negotiate better terms with your preferred lender.
The good news is that seeking more than one pre-approval won’t really damage your credit score. Shopping multiple mortgage lenders within a short time period (45 days) generally only counts as a single credit inquiry. Since you have nothing to lose (except your own money, if you just take the first offer you’re given), make sure you do some mortgage homework.
The Bottom Line
If you’re serious about buying a house, the pre-approval process is an important step to take. In ultra competitive housing markets, having a pre-approval letter to go with your offer could be the difference between buying your dream house or being forced to keep looking. Even if going through the process makes you face some unfortunate financial truths (like your debt is hindering your ability to buy a house or your down payment is simply too small), at least you’ll know exactly where to focus your efforts to achieve your house dreams.
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