As you search for a home, there’s an important step to take to help you know what you can afford: getting pre-approved for a mortgage.
You might have a sense of your house-hunting budget or the monthly mortgage payment you can handle, but one way to clarify is going through the pre-approval process. Before lenders decide to pre-approve you for a mortgage, they will look at several key factors: your credit history and credit score, your debt-to-income ratio, your employment history and income, and your assets and liabilities.
Think of a mortgage pre-approval as a physical exam of your finances. Expect lenders to poke and prod into all corners of your financial life to ensure you’ll repay your mortgage. As a borrower, it’s important to know what a mortgage pre-approval does (and doesn’t do), and how to boost your chances of getting one.
Pre-Qualification or Pre-Approval?
You’ve likely heard the term “pre-qualification” used interchangeably with pre-approval, but they are not one and the same. With a pre-qualification, you provide an overview of your finances, income and debts to a mortgage lender who then gives you an estimated loan amount. However, the lender doesn’t pull your credit reports or verify your financial information. Accordingly, pre-qualification is a helpful starting point to determine what you can afford, but carries no weight when you make offers.
On the other hand, a pre-approval involves filling out a mortgage application and providing your Social Security number, so a lender can do a hard credit check. A hard credit check is triggered when you apply for a mortgage and a lender pulls your credit report and credit score to assess your creditworthiness before making a decision to lend you money. These checks are recorded on your credit report and can impact your credit score. On the other hand, a soft credit check is when you pull your credit yourself, or when a credit card company or lender pre-approves you for an offer without you asking.
Also, you’ll list all of your bank account information, assets, debts, income and employment history, past addresses, and other key details for a lender to verify. Why? Above all, a lender wants to ensure you have the ability to repay your loan. Lenders also use the provided information to calculate your debt-to-income and loan-to-value ratios, which are important factors in determining interest rate and ideal loan type.
When Should I Get Pre-Approved?
Mortgage pre-approval letters are typically valid for 60 to 90 days. Lenders put an expiration date on these letters because your finances and credit profile could change. When a pre-approval expires, you’ll have to fill out a new mortgage application and submit updated paperwork to get another one.
If you’re just starting to think about buying a home and suspect you might have some difficulty getting a mortgage, going through the pre-approval process can help you identify credit issues — and give you time to address them. Seeking pre-approval six months to one year in advance of a serious home search puts you in a stronger position to improve your overall credit profile. You’ll also have more time to save money for a down payment and closing costs.
When you are ready to write offers, a seller often wants to see a mortgage pre-approval and, in some cases, proof of funds to show that you’re a serious buyer. In many hot housing markets, sellers have an advantage because of intense buyer demand and limited homes for sale; they’re unlikely to consider offers without pre-approval letters.
How the Pre-Approval Process Works
Applying for a mortgage can be exciting, nerve-wracking and confusing. Some online lenders can pre-approve you within hours, while other lenders could take several days. The timeline depends on the lender and the complexity of your finances.
For starters, you’ll fill out a mortgage application. You’ll include your identifying information, as well as your Social Security number to pull your credit. Mortgage credit checks count as a hard inquiry on your credit reports, which may impact your credit score, but if you’re shopping multiple lenders in a short timeframe (usually 45 days for newer FICO scoring models) the combined credit checks count as a single inquiry.
Here’s a sample of a uniform mortgage application. If you’re applying with a spouse or other co-borrower whose income you need to qualify for the mortgage, both applicants will need to list financial and employment information. There are eight main sections of a mortgage application:
- Type of mortgage and terms of loan – The specific loan product for which you’re applying; the loan amount; terms, such as length of time to repay the loan (amortization); and the interest rate.
- Property information and purpose of loan – The address; legal description of the property; year built; whether the loan will be used for purchase, refinance or new construction; and the intended type of residency (primary, secondary or investment).
- Borrower information – Your identifying information, including full name, date of birth, Social Security number, years of school attended, marital status, number of dependents and address history.
- Employment information – The name and contact information of current and previous employers (if you’ve been at your current position less than two years), dates of employment, title and monthly income.
- Monthly income and combined housing expense information – A listing of your base monthly income, as well as overtime, bonuses, commissions, net rental income (if applicable), dividends/interest, and other types of monthly income such as child support or alimony. Also, you’ll need an accounting of your monthly combined housing expenses, including rent or mortgage payments, homeowners and mortgage insurance, property taxes, and homeowner’s association dues.
- Assets and liabilities – A list of all bank and credit union checking and savings accounts with current balance amounts, as well as life insurance, stocks, bonds, retirement savings, and mutual funds accounts and corresponding values. You’ll also need to list all liabilities, which include revolving charge accounts, alimony, child support, auto loans, student loans and any other outstanding debts.
- Details of transaction – An overview of the key transaction details, including purchase price, loan amount, value of improvements/repairs, estimated closing costs, buyer-paid discounts, and mortgage insurance (if applicable). (Note: The lender will fill in much of this information.)
- Declarations – An inventory of any judgments, liens, past bankruptcies or foreclosures, pending lawsuits or delinquent debts. You’ll also be asked to state whether you’re a U.S. citizen or permanent resident, and whether you intend to use the home as your primary residence.
What Happens Next?
A lender is required by law to provide you with a three-page document called a loan estimate within three business days of receiving your completed mortgage application. This paperwork notes whether the mortgage has been pre-approved and outlines the loan amount, terms and type, interest rate, estimated interest and payments, estimated closing costs (including any lender fees), an estimate of property taxes and homeowner’s insurance, and any special loan features, such as balloon payments or an early prepayment penalty, for example. It also specifies a maximum loan amount, based on your financial picture, to help you narrow down your home-buying budget.
If you’re pre-approved for a mortgage, your loan file will eventually be transferred to a loan underwriter who will verify your documentation against your mortgage application. He or she will also ensure you meet the borrower guidelines for the specific loan program for which you’re applying.
Documentation Needed for a Mortgage Pre-Approval
After submitting your mortgage application, you’ll need to gather a number of documents to verify your information. Preparation and organization on your end will help the process go more smoothly. Here’s a list of documents you need to present in order to be pre-approved, or to secure final loan approval before closing:
- 60 days of bank statements
- 30 days of paystubs
- W-2 tax returns from the previous two years
- Schedule K-1 (Form 1065) for self-employed borrowers
- income tax returns
- asset account statements (retirement savings, stocks, bonds, mutual funds, etc.)
- driver’s license or U.S. passport
- divorce papers (to use alimony or child support as qualifying income)
- gift letter (if funding your down payment with a financial gift from a relative)
If you’re a self-employed borrower, you might be asked to provide additional documents to show a consistent income and work history of at least two years. Some documents requested may include a profit/loss statement, a business license, your accountant’s signed statement, federal tax returns, balance sheets and bank statements for previous years (the exact amount of time depends on the lender).
If your situation makes it difficult to get a traditional mortgage, here are two options geared specifically for self-employed borrowers:
Stated Income/Stated Asset Mortgage (SISA)
This type of mortgage is based on the income you report to the lender without formal verification. Stated income loans are sometimes also called low-documentation loans because lenders will verify the sources of your income rather than the actual amount. Be prepared to provide a list of your recent clients and any other sources of cash flow, such as income-producing investments. The bank may also want you to submit an IRS Form 4506 or 8821. Form 4506 is used to request a copy of your tax return directly from the IRS, preventing you from submitting falsified returns to the lender, and costs $39 per return. But you may be able to request Form 4506-T for free. Form 8821 authorizes your lender to go to any IRS office and examine the forms you designate for the years you specify, free of charge.
In this type of loan, the lender will not seek to verify any of your income information. This may be a good option if your tax returns show a business loss or a very low profit. Because it is riskier for the bank to lend money to someone with an unverified income, expect your mortgage interest rate to be higher with either of these types of loans than with a full-documentation loan. Low and no documentation loans are called Alt-A mortgages, and they fall between prime and subprime loans in terms of interest rates.
Down Payment Gifts
Many loan products allow borrowers to use a financial gift from a relative toward the down payment. If you go this route, a lender will ask you to complete a standard gift letter in which you and the gift donor aver that the gift isn’t a third-party loan with an expectation of repayment. Otherwise, such an arrangement could increase your debt-to-income ratio, impacting your final loan approval. Additionally, both you and the donor will have to provide bank statements to source the transfer of cash funds from one account to another.
What’s in a Pre-Approval Letter?
Your lender will provide you with a pre-approval letter on official letterhead. This official document indicates to sellers that you’re a serious buyer and verifies that you have the financial means to make good on an offer to purchase their 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 is submitted with your offer; some sellers might also request to see your bank and asset statements.
Getting a pre-approval doesn’t oblige you to borrow from a specific lender. When you’re ready to make an offer, you can choose the lender that offers you the best rate and terms for your needs. Nor does getting a pre-approval guarantee that a lender will approve you for a mortgage. This is especially true if your financial, employment and/or income status changes during the time between pre-approval and underwriting.
Which Factors Impact Your Mortgage Pre-Approval
If you want to maximize your chances of getting a mortgage pre-approval, you need to know which factors lenders evaluate in your financial profile. They include your:
- debt-to-income ratio (DTI)
- loan-to-value ratio (LTV)
- credit history and FICO score
- income and employment history
Your DTI ratio measures all of your monthly debts relative to your monthly income. Lenders add up debts such as auto loans, student loans, revolving charge accounts and other lines of credit, plus the new mortgage payment, and then divide the sum by your gross monthly income to get a percentage. Depending on the loan type, borrowers should maintain a DTI ratio at or below 43% of their gross monthly income to qualify for a mortgage. The higher your DTI ratio, the more risk you pose to lenders because you could be more likely to struggle repaying your loan on top of debt payments. Having a lower DTI ratio can qualify you for a more competitive interest rate. Before you buy a home, pay down as much debt as possible. Not only will you lower your DTI ratio, but you’ll also show lenders that you can manage debt responsibly and pay bills on time.
Another key metric lenders use to evaluate you for a mortgage is your loan-to-value ratio, which is calculated by dividing the loan amount by the home’s value. A property appraisal determines the property’s value, which might be lower or higher than the seller’s asking price. The LTV ratio formula is where your down payment comes into play. A down payment is an upfront sum of money you pay, in cash, to the seller at the closing table. The higher your down payment, the lower your loan amount and, as a result, the lower your LTV ratio. If you put down less than 20% percent, you might be required to pay for private mortgage insurance, or PMI. It’s a type of insurance coverage that protects lenders in the event you fail to repay your mortgage. To lower your LTV ratio, you either need to put more money down or buy a less expensive house.
Credit History and Score
Lenders will pull your credit reports from the three main reporting bureaus – Equifax, Experian and Transunion. They’ll look for your payment history and whether or not you pay bills on time, how many and what type of credit lines you have open, and the length of time you’ve had those accounts. In addition to a positive payment history, lenders analyze how much of your available credit you actively use, also known as credit utilization. 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 account for your FICO score, a credit score model used by many types of lenders (including mortgage lenders).
If you have not opened credit cards or any traditional lines of credit such as an auto or student loan, you might have trouble getting a mortgage pre-approval. You can build your credit by opening a starter credit card with a low credit line limit and paying off your bill each month. It could take up to six months for your payment activity to be reflected in your credit score so be patient as you build your credit profile.
Employment and Income History
When you apply for a mortgage, lenders go to great lengths to ensure you earn a solid income and have stable employment. That’s why lenders request two years’ worth of W-2s and contact information for your employer. Essentially, lenders want to ensure that you can handle the added financial burden of a new mortgage. You’ll also be asked to provide salary information, so a lender has evidence that you earn enough money to afford a mortgage payment and related monthly housing expenses. You’ll also have to provide 60 days (possibly more, if you’re self-employed) of bank statements to show you have enough cash in hand for a down payment and closing costs.
What to Do If You’re Denied a Mortgage
After reviewing your mortgage application, a lender will usually give you one of three decisions: pre-approved, denied outright or pre-approved with conditions. In the third scenario, you might need to provide extra documentation or lower your DTI ratio by paying down some credit accounts to satisfy the lender’s conditions. If you’re denied outright, the lender should explain exactly why and provide you with resources on how to best tackle the problems.
In many cases, borrowers need to work on boosting their credit score and ironing out a spotty payment history. Once you know what you need to address, you can take the time and effort to improve your credit and financial health in order to get a better mortgage deal when you’re ready to embark on your home search. Doing so can save you significant money on mortgage pricing and ensure you get lower interest rates and terms when shopping different lenders.
The Bottom Line
Go through the pre-approval process with several lenders to shop interest rates and find the best deal. Again, you’ll want to shop mortgage lenders within a 45-day period, so all credit checks count as one hard inquiry, with minimum impact on your credit score. And if you’re just starting to think about homeownership, the pre-approval process can help you get your credit and finances in better shape for when the time is right.
Remember that a mortgage pre-approval doesn’t necessarily guarantee you a loan. Pre-approval letters are conditional on your financial and employment information being truthful and consistent before your loan closes. Likewise, if you fail to disclose key information – a divorce, an IRS tax lien or some other issue – and a loan underwriter finds out about it later, you can be denied a loan approval
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