Mortgage Pre-Approval Process

Mortgage pre-approval is an important step in any home buying process.  Being proactive and identifying any red flags early on give you the chance to take steps to correct any errors or deficiencies that could stand in the way of getting the best possible home mortgage.  Many home sellers also prefer buyers to have a pre-approval letter and will be more willing to negotiate when a buyer can show proof of financing.

Here are some important things you should know about mortgage pre-approval.

The Difference Between Pre-qualification and Pre-approval

Like many people you may think that the terms pre-qualification and pre-approval are interchangeable.  But they are not the same thing. 

A mortgage pre-qualification is an overview of your finances, debts, and income that a lender will use to determine an estimated loan amount that you will qualify for. 

A mortgage pre-approval carries more value to you because it means you have gone through the actual process of filling out a mortgage application and providing the necessary information a lender needs to do a hard credit check.  This involves looking at your credit report, checking your credit score and determining your credit worthiness before deciding whether or not to lend you money.

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Factors that Influence Pre-Approval

It’s important to understand what lenders consider important when reviewing your financial information before making a decision to lend you money.  The key factors include:

Debt-to-Income Ratio (DTI)

Your DTI ratio is a measure of your monthly debts compared to your monthly income.  Lenders add all your financial obligations such as credit card payments, auto loans, student loans, and what a new mortgage payment will be and then divide it by the sum of your gross monthly income.  This produces a percentage to determine the level of risk you pose to the lender.  The higher your DTI ratio, the more risk you pose to lenders.  The lower your DTI ratio, the more likely it is that you will be able to secure a more competitive loan rate.

Loan-to-Value Ratio (LTV)

The LTV ratio is calculated by dividing the loan amount by the home’s value.  The amount of your down payment can have a big impact on this number.  The higher your down payment, the lower the LTV will be. 

Credit History and FICO Score

Lenders will pull your credit report from Equifax, Experian and Transunion and look at your payment history to see if you’ve been diligent and on time in paying your bills.  They will also look at the type of amount of credit and lines you have open as well has how much credit you actively use.  Maintaining a credit utilization rate at or below 30% helps boost your credit score, and it shows lenders a responsible, consistent pattern of paying your bills and managing debt wisely.  All of these items determine your FICO score which is a credit score model that is used widely in the lending business.  

Income and Employment History

Lenders want to make sure you’re a good credit risk so they will scrutinize your income level and how stable your work history has been.  Lenders use this to seek reassurance that borrowers can handle the additional burden of a mortgage.  You will need to supply a number of supporting documents to verify these things. 

Documents Needed for Mortgage Approval

To make sure the pre-approval process goes as smoothly as possible, you’ll need to supply several documents to the lender, including:

  • 60 days of bank statements
  • 30-60 days of paystubs
  • Social Security cards/numbers
  • W-2 tax returns from the previous two years
  • income tax returns for the past two years
  • bankruptcy and foreclosure information
  • asset account statements such as for stocks, bonds, retirement accounts, mutual funds, etc.
  • driver’s license or U.S. passport
  • divorce papers if applicable (to use alimony or child support as qualifying income)
  • a gift letter if funding the down payment with a financial gift from a relative

If you’re self-employed, you will need to provide a Schedule K-1 (Form 1065).  You may also be asked to provide additional documents to show a consistent income and work history of at least two years. This may include a profit/loss statement, a business license, an accountant’s signed statement, federal business tax returns, and balance sheets and bank statements for previous years.

Getting a Pre-Approval Letter

If you are pre-approved, your lender will give you a pre-approval letter that verifies you have the financial resources to make a valid offer to purchase a home.   

Pre-approval letters typically include the purchase price, loan program, interest rate, loan amount, down payment amount, expiration date, and the property address. The letter prepared on official letterhead and is submitted with the offer.

You are not bound to borrow from a specific lender if you submit a pre-approval letter.  You are free to choose the lender that offers the best rate and terms for your specific needs. 

Typically, mortgage pre-approval letters are valid for 60-90 days. Lenders put an expiration date on these letters because your finances and credit profile can change over time. When a pre-approval expires, a new mortgage application will need to be filed out and updated paperwork will need to be submitted to get another one.

If You’re Denied a Mortgage

After you’ve submitted a mortgage application, a lender will give you one of three possible decisions.  You will either be pre-approved, denied, or pre-approved with conditions. 

If you’re pre-approved with conditions, you will know what steps you need to take to remove those conditions that may create a barrier to actually getting a loan.  You might need to supply more documentation or lower your debt-to-income ratio by paying down some bills.

You may also need to improve your credit score and address a less than perfect payment history.  Once you know exactly where the shortcomings are, you can begin to address them so that you can get the best possible mortgage terms when you’re ready to move forward. 

Conclusion

A mortgage pre-approval does not always guarantee that you will be funded for a loan.  Pre-approvals are subject to verification that your financial and employment information is truthful and remains consistent before your loan closes.  If you fail to disclose information or lie about important details, an underwriter has the right to deny your loan at a later date.