The home buying process can be time consuming, especially if your desired location is not in your current neighborhood. In today’s busy world, where we are constantly interacting with the world from dawn to dusk and beyond, it’s hard to set apart time to get a pre-approval letter from a lender. However, there are many benefits for going through the process, which will save you time in the future.
A prequalification letter is more of a marketing term to attract customers for a wide variety of financial institutions. I’ve been “pre-qualified” for major credit cards since high school, without even an income source back in the day. The qualification process is a quick credit check, but omits a detailed inspection, therefore it lacks substantial value. Numerous lenders will prequalify you based in limited information because it’s a quick process for both parties involved and doesn’t have any financial guarantee involved.
The pre-approval process is a more scrutinous task, but it has major benefits down the road for the buyer.
Let’s first talk about the process first because it will help you understand the steps involved.
Income: You will need a proof of all possible income you wish to claim, be it the W2 or 1099 documentation from work, for the past two years; this includes any extra income from child support, alimony, or other forms of payments. You will also need tax returns for the last two years as well. If anyone has done their own taxes, they can tell you how arduous a process it is, especially tallying numbers and acquiring the correct documents. This will be the most time-consuming part of pre-approval stage because you must gather the documents and make sure the numbers are correct.
Tip: If you are a 1099 employee (i.e. independent contractor such as yours truly), the process is a bit more complicated. Independent contractors have fluctuating incomes, so you may have X amount of income in one year, and X-Y amount of income the next year. In this case, the bank will average your income for two years to get a better picture. However, you can submit an extra third years’ worth of income if it can help you raise the average. Independent contractors also have numerous tax write-offs, that lower their taxable income. When you are driving with me to view your perfect home, the gas mileage is a tax write-off for me. However, the write-offs lower your income and therefore the lender may not qualify you at the level of money you make. The lender (and the IRS) sees the write-offs as crucial to the continuation of your business, so they don’t factor in a reduction in the future. They expect you to spend the same amount of money to sustain your business, therefore your profit is the taxable amount. This is where having a pre-approval process helps, because it lets you know beforehand about the exact amount of mortgage you are qualified for, before you start looking at houses.
Assets: Essentially, how much liquid assets do you have? Most loans (unless you are a veteran qualifying for a VA loan) require a down payment, which the lender needs to see that you have sufficient funds. There should also be money for closing costs and tax reserves, among other costs that may be subject to individual situations. It’s important that the assets are liquid, as opposed to the frowned upon non-liquid assets. A car you plan to sell is a non-liquid asset because you have to advertise, secure a buyer for desired price, and execute the transaction, which may take considerable time. Therefore, it’s important to have the ability to show liquid assets that are readily available by closing time to cover the costs of the home purchasing transaction.
Tip: The assets process is vital to the home purchasing process because the lender will give you a net sheet highlighting the amount of money involved in the process. The sheet is valuable because there are times where clients will underestimate the costs of closing on a house. This is where the pre-approval process comes in handy, because you can turn non-liquid assets into liquid assets in the time frame of scouting homes to purchase. Maybe the expensive drumkit collecting dust or the unwanted automobile can be sold in the meantime to acquire those assets. If you find out after finding the perfect house, you may not have time to transform the assets to liquid, therefore risk the chance of losing your opportunity for the house. This is also a good time to ask friends or family members for a gift to help you with down payments, albeit they need to certify that it’s not a loan. In that case, make it very close friends and family members.
Employment Verification: This one is self-explanatory, the lender wants to know that you are employed gainfully, which assures a greater chance of repayment for their loan. They will most likely call your place of employment to verify the information you provided, and confirm your salary details.
Tip: If you are in the process of buying a home, please don’t quit your job. The lender is using your past pay history to project into the future and calculate the probability of full repayment of the loan. If you quit your job in the middle of the process, it makes a drastic change to future projections for income, therefore reducing the chance of approval. Furthermore, the whole sub-prime loan issue from the real estate crash a decade ago causes lenders to be extra careful in approving loans without true verification.
Credit Score: In terms of lending, this is the most publicized aspect because the credit score is used for almost any type of loan, even jobs. The credit score may be antiquated or flawed, but it’s widely used in the country, and it becomes a monumental part of the process. Lenders will do a hard check on your credit score, and it has a major impact with your interest rates, and discount points.
Tip: If you have bad scores, we can put you in touch with financial planners that help repair credit scores. They will chart the steps you will need to take to raise the scores in a given period of time, and guide you through the process. Credit scores are notoriously filled with wrong information, so there are times where you or a financial planner can file an appeal to have a claim removed from your credit report. In either case, a pre-approval process lets you find these issues and gives you time to correct or manage your credit report before you are putting in an offer for your dream house. A simple appeal of a fraudulent claim may raise your credit score enough to qualify you for a larger loan or superior interest rate. It’s always good to find out any issues with the lending process, so there is ample time to have a positive impact.
Debt to Income Ratio: The lender assesses your debts (student loans, car loans, mortgage loans, any other forms of documented loans) to your income in the mortgage process. The lender wants to see the amount of money from your income earmarked for other payments, and then calculate the probability of you being able to afford repayment of the home loan. It’s simple, but it is a major factor.
Tip: Here is where things may cause a problem for home buyers. If you are buying a home, don’t buy the new car or furniture until after the closing date. It will affect your assets (if you pay cash for these items), or debt to income ratio (if you finance them) and have a negative impact on your financial evaluation from the lender. However, a pre-approval process can highlight how much fluid money is necessary for the transaction, so it lets you get a better idea of the funds available for other purchases. For example, if you need X amount of money for a home, and you have X + Y amount in your bank, then the Y amount is available for you to make purchases without effecting the mortgage process. It helps you determine the amount of money that has to be set aside or the leeway you have in other purchases during the process.
As a Realtor, I don’t want you to spend time looking at homes, falling in love with a certain home, and then be disappointed to learn that you don’t qualify for the price point. It’s much easier on you to be pre-approved because you know exactly how much you can afford and what price range to target. My job is to show you homes, so I’m happy to showcase houses in any price range. However, you are taking time from work and busy lives to look at these homes so it’s much more efficient for a prospective buyer to know the financial parameters.
A pre-approval letter has a positive effect in submitting an offer on the listed home, because the sellers realize the chances of complications are smaller with a pre-approval letter, as opposed to a pre-qualification letter. In the case of similar offers, it’s more likely that the seller picks the buyer with the pre-approval letter. It’s natural psychology since they want assurances much like the seller that the process will go smoothly, rather than uprooting their lives only for the mortgage to fall through at the last minute. There are going to be days where you will travel with your real estate agent (Which I hope would be me, since you are reading this), so make the most efficient use of your time and target homes that are financially viable.
Tip: You should maintain a close relationship with the lender, because you can get letters for different amounts of approval. For example, you are approved for a mortgage at $400,000, but the house you love is listed at $330,000. You want to make an offer for $325,000, but if you submit a pre-approval letter stating you qualify for $400,000, then the seller is going to be less likely to negotiate. However, the lender can write a letter stating that you are approved for $325,000, which fits the offer, but also helps you in negotiations.
The pre-approval letter can be a great asset for any prospective buyer because it simplifies the process to a great extent, and helps identify any problems that may arise in the lending process. A pre-approval doesn’t mean that things can’t go wrong later, because the lender will run these exact processes once again to make sure the financial situation hasn’t changed.
Thank you for reading this, if you have any further questions, please feel free to contact me via email or phone.
Disclaimer: I’m not a financial planner, therefore the financial advice offered in this article is an outline. Since every financial situation is unique, you should consult a financial planner for individual requirements.