In order to buy a home, you likely need to borrow the funds. But how do you know if your loan will be approved? A mortgage lender can pre-approve you, which lets you know exactly how much home you can afford before you start your home search. It also signals that you are a serious buyer as you begin the home buying process.
What Is Mortgage Pre-approval?
A mortgage pre-approval is a piece of paper from a lender stating that you’ve been approved for a home loan up to a certain amount. This letter can then be shown to a real estate agent or a home seller during your house hunting to demonstrate that you have the financing lined up. Since many real estate agents deal with buyers who place an offer, only to have financing fall through, a pre-approval can give you an advantage over others seeking homeownership.
But a pre-approval letter doesn’t just make you more competitive as a buyer. If you’re looking for a home loan, you're limited in the amount you can borrow. Pre-approval lets you know that limit before you start shopping so you don’t waste time looking at homes with purchase prices and closing costs you can’t afford.
How Does Pre-approval Work?
Homebuyers may find that instead of a pre-approval, a lender offers a mortgage pre-qualification. The two terms can be used interchangeably, but you should clarify what a lender’s process is. Some merely do a preliminary check into your financial information, while others go into detail.
In some cases, lenders use the term pre-qualification to refer to a less intrusive process. In this case, the loan officer may only do a soft credit check, which won’t impact your score. If a lender uses pre-qualification in this sense, you might not get an official letter stating that you’ve been pre-approved, as only preliminary steps were taken to qualify you.
While it may seem tempting to have a quick-and-easy pre-approval process, a more thorough process can have its benefits. If a lender has gone in-depth on your financials, it's less likely that there will be surprises when you finally find a new home. It's important to remember that a pre-approval is not a final approval. It just demonstrates that a lender has gone through its own process to pre-qualify you.
Read More: Where to Get Preapproved for a Home Loan?
Why Get Preapproved?
A pre-qualification states that a lender has confidence that you’ll be approved for that amount on a home loan.
Here are a few benefits of pre-approval:
- Some sellers require it: The bottom line is, you may be excluded from some homes if you don’t have pre-approval. If a seller has multiple offers coming in, your offer can easily be trumped by someone who has the financing lined up. Some sellers decline offers from buyers who aren’t pre-approved, especially in a market where numerous buyers are competing for the few available homes for sale.
- Issues will be highlighted: If there are issues with your credit report or financial health, the pre-approval process can unearth them. That gives you the chance to improve the problems in a time frame you set before you start your home search.
- You’ll know what you can afford: A pre-approval gives you an idea of what the lender will let you borrow. But you can also crunch the numbers to see how much of a home you can afford, factoring in your down payment and interest rate. This is a huge help as you narrow down the homes for sale in your price range.
How to Get Preapproved
Getting pre-approved works similarly to getting a loan in that you complete a mortgage application and provide some documentation. But it’s important to note that you aren’t committed to using that lender just because you made a loan application and have your pre-approval there.
Depending on the lender, the following may be a part of your pre-approval process:
- Credit score verification: The lender may pull your credit report. In many cases, this will be a hard inquiry credit pull, which means it could impact your credit score in the short term.
- Income verification: Part of getting pre-approved is showing you have the income to make the monthly mortgage payment. This could require providing pay stubs, bank statements or tax returns.
- Debt disclosure: Your level of debt also impacts your ability to pay. You need to list your debts, including credit card balances, student loans and car loans.
Eligibility for Pre-approval
Prior to seeking pre-approval, take a look at your bank accounts and credit score and gather the past couple of years of tax returns, some pay stubs and bank statements. If you have any other sources of income, like Social Security payments or alimony, be prepared to show documentation of those, as well.
Here's what mortgage lenders typically look for:
Credit score: To qualify for a conventional mortgage loan, lenders generally want to see a credit score of at least 620, and some go as high as 660. FHA loans accept scores as low as 500 if you can make a down payment of at least 10 percent, or 580 for a down payment of 3.5 percent.
Debt-to-income ratio (DTI): Lenders also look at the percentage of your income that goes toward debt, known as a debt-to-income ratio. To determine this, divide your total monthly debt by your total monthly income. You usually need a debt-to-income ratio of no more than 43 percent. Some lenders go as low as 36 percent.
Read More: How to Check Your Credit Score
Using Your Mortgage Pre-approval
If you’re pre-approved, it’s important to pay close attention to the valid date on it. Many are only valid for 30 to 90 days, which means you need to kick off your home buying as soon as possible. The letter lists the maximum amount of the approval, as well as the terms under which the approval will be valid.
Take a copy of this letter to your real estate agent and start your search. If you’re planning on buying without the help of a real estate agent, keep the letter on hand to show when you put an offer on a house. Make sure you not only stay beneath the maximum approval amount but also look at how much you’ll have to pay each month.
Finding a House with Pre-approval
Your mortgage pre-approval letter lists the maximum amount you’re approved to borrow. That doesn’t mean you have to use the full amount. You need to find a home that gives you a monthly mortgage payment that fits your budget.
Here are a few things you’ll be paying each month once you finalize your mortgage loan:
- Borrow amount: Unless you can find a no down payment loan, you won’t be borrowing the full amount. If you’re buying a $300,000 home with a 3.5 percent down payment, you bring $10,500 to the table at closing. That means you only need to borrow $289,500.
- Loan term: Your loan amount is divided by the number of months you remain in the house. If you take a 30-year loan, that $289,500 will be divided into 360 monthly payments. Mortgage loans are structured so that you’ll pay less toward the principal in the early days of your loan, increasing the longer you live in the house.
- Interest: You’re assigned an interest rate when you get your final loan approval. This interest is combined with your principal and paid with each monthly payment. More of your payment goes toward interest in the early days of your mortgage, gradually fading so that more of your payment tackles your principal.
- Homeowners insurance: To make things more convenient for borrowers and protect their investment, lenders add your homeowners insurance premiums to your monthly payment. The mortgage company makes sure those insurance premiums are paid on your behalf.
- Property taxes: All homes come with property taxes. This is built into your monthly mortgage payment and paid to the local government on your behalf.
- Homeowners Association (HOA) fees: Although this isn’t part of your mortgage payment, you should look for it as you’re home shopping. HOA fees are charged by many communities to help pay for costs of upkeep on common spaces and amenities. These fees can be as little as $20 a year or as high as $500 or more a month.
Read More: What Is PMI?
Locking in Your Interest Rate
The pre-approval process usually doesn’t include an interest rate lock-in. That means if the interest rate climbs while you’re looking for a home, you’ll pay more in interest. But once you’ve found a home, you can request an interest rate lock-in.
For best results, shop multiple lenders and go with the best offer. During the mortgage quote process, ask the lender at what point the interest rate is locked in. An interest rate lock-in has an expiration date. Determine how many days that rate will hold just in case your closing is delayed.
Read More: Can You Back Out of a Locked-In Rate?
What to Do If Denied
In some cases, you may be denied a pre-approval. There are a variety of reasons this could happen. If you’re self-employed or your employment history is volatile, a lender may turn you down. The lender might not see your credit history or debt-to-income ratio as fitting within its parameters.
If you’re turned down for a pre-approval letter, here are some steps to take:
- Determine why: Ask the lender what the issue was. This allows you to make changes before you shop for other lenders.
- Consider nontraditional lenders: Each lender has its own policies for approving loans. Small, local banks and credit unions sometimes have more flexibility. You could also have better luck with online lenders.
- Dispute credit report entries: If your credit score is the problem, the first step is to request a free copy of your credit report. Look at any entries that are erroneous and follow the reporting agency’s steps to dispute them. Some creditors won’t respond by the deadline, allowing you to have that entry removed.
- Reduce debts and try again: You’ll be at an advantage if you can show that you have the income available to make your monthly payment. Work on reducing your debts so that less of your monthly income goes toward paying them off.
Dealing with Loan Limits
What happens if you find your dream home, but it exceeds your approved loan amount? Keep in mind that your mortgage pre-approval is one lender’s nonbinding commitment. You might be able to find another lender who will loan you more. If you can find a lender or loan program that will pre-qualify you using a soft credit pull, which doesn’t affect your score, it can help to see if you can get a higher limit.
But an increased loan amount also means larger monthly payments. It might be better to find a way to reduce your loan amount by coming up with a larger down payment or paying for mortgage points at closing. With points, you can buy down the interest rate by putting down even more money.
Read More: What Is "Points" on a Mortgage?
A mortgage pre-approval letter can make your home shopping process much easier. In a seller’s market, it may be the one thing that has a seller accepting your offer when multiple offers are coming in. Once you’ve found a home, you can get quotes from other lenders and choose the one that offers the best rates.
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.