With mortgage preapproval, a lender checks your credit and evaluates details about your income, debts and assets using documents including pay stubs, personal bank statements and your federal personal income tax returns.
The lender uses this information to determine whether you're preapproved and the size of the mortgage you can receive. To reduce risk brought on by the COVID-19 pandemic and economic slowdown, lenders are generally tightening eligibility standards for all borrowers and stepping up the income verification process for self-employed borrowers.
Understanding these changes and doing a little prep work can help when you're ready to ask for preapproval.
Mortgage Preapproval vs. Prequalification
As you go through the mortgage application process, you may hear the terms "preapproval" and "prequalification" used almost interchangeably. Both refer to a letter that says a lender is willing to give you a loan and feels confident you have the resources to pay for a mortgage, but they are two different things.
"A prequalification is just a quick snapshot of where the borrower's finances are, with basically some verbal information that they are providing," says Paul Wendland, mortgage banker with CenterState Bank Mortgage. "A preapproval is a little bit more in-depth. We're actually obtaining the formal income documentation and asset information, such as bank statements and retirement accounts, and we review their credit more thoroughly."
You'll want to prequalify when shopping for mortgage lenders, as prequalification will give you an idea of the loan amount, interest rate and other terms you might expect. Preapproval gives you a clearer sense of those terms, as it's based on a more comprehensive review. When you're confident you've found good offers from a few lenders, you should move forward with mortgage preapprovals.
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Getting preapproved is "crucial," says Trent Davis, real estate broker associate with Coldwell Banker Residential Real Estate - Florida. "If you find that piece of real estate that you want, a seller for the most part won't consider your offer until you can supply a preapproval letter."
This also helps you address potential issues with your application and find a home you could be approved to buy, Davis adds.
The preapproval letter usually includes an estimate of your loan amount, interest rate and monthly mortgage payment.
Although a preapproval puts you ahead of other buyers who don't have one, it's not a commitment from the bank. At the same time, it also doesn't bind you to a particular bank's mortgage, so you can use the preapproval letter to shop around for about 30 to 60 days.
>How to Get Preapproved for a Mortgage
Understanding the mortgage preapproval process can help you prepare your finances. Here are the steps you should follow:
Make a plan. Determine how much you can afford to pay toward a loan every month before the lender makes its recommendation.
The amount you're preapproved for depends on your debt-to-income ratio. Most lenders like to see that your combined debts equal less than 36% of your gross income, your income before taxes, though you might be approved with a 45% DTI. Only you know how much you're comfortable spending every month, though.
Lenders are generally approving borrowers with less debt. The average borrower had an average back-end DTI ratio of 35% in spring 2020. This is down from 38% at the same time last year, according to a May 2020 report from mortgage software firm Ellie Mae.
To close on a mortgage, you'll also need the funds to make a down payment. A 20% down payment is usually recommended for a conventional mortgage, but that amount may not be required. You'll likely need to pay closing costs, which usually are about 3% to 5% of the loan amount.
Check your credit reports. Your credit history and credit scores are major factors in whether you're approved and what interest rate a lender charges you. The healthier your credit, the more likely you are to get approved at a good rate.
Some mortgage lenders have increased their credit score requirements to shore up risk during the COVID-19 pandemic. In the Ellie Mae report, the average credit score for all mortgage applicants was 750 in May, up from 728 in the same month in 2019. Requirements vary by lender.
If there's room for improvement, you can boost your credit score by doing things like paying down debt and making on-time payments every month. Through April 2021, you can check your credit reports from each of the three credit bureaus for free every week at AnnualCreditReport.com.
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Collect your documents. Lenders will check your income, assets, debts and credit history to see whether you should be preapproved for a mortgage. Gather the following before applying:
-- W-2 forms from your employer for the previous two years
-- Current pay stubs
-- Federal personal income tax returns for the previous two years
-- Personal bank statements for the previous two months
-- Identification, such as a driver's license
Documentation requirements are temporarily higher for independent contractors and self-employed workers, who often have less-stable income. Self-employed borrowers may also need to provide:
-- An audited profit-and-loss statement that reports business revenue, net income, and expenses and debts
-- Business bank account statements for the previous two months
-- A business tax return for the most recent year
Research different lenders. It can take years or decades to pay off a mortgage, so know your lender before you commit. Research the lender and servicer on the Consumer Financial Protection Bureau's complaint database and with the Better Business Bureau. Talk to lenders about their loan closing timeline and ask any questions you have, taking notes on your customer experience.
Apply for preapproval and compare offers. You can apply for preapproval after you've used prequalification to narrow down your options to a few lenders with the best rates and fees. With the solid offer of a preapproval, you may be able to negotiate better terms by pitting lenders against one another.
"I would suggest getting preapproved through one lender and taking it to someone else and say, 'Hey, can you beat this?'" Davis says. A small difference in the interest rate can make a substantial difference in how much you pay over 30 years.
How Long Does It Take to Get Preapproved for a Mortgage?
The preapproval process may take one to three days, but the time frame could stretch longer during periods of high demand, when lenders are pinched for time. It also depends on how long it takes you to gather documents. Speed things up by gathering everything before you apply.
Once you're on the phone with a lender, that lender will use an automated underwriting system to analyze your documents and pull your credit.
Do Mortgage Preapprovals Affect Your Credit Score?
Getting a home loan preapproval can lower your credit score by a few points because the lender performs a hard pull on your credit reports during the process.
However, if you're shopping around and multiple lenders check your credit over a 45-day window, the credit bureaus generally count these inquiries as a single credit pull.
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Improve Your Chances of Getting Preapproved
There are ways to tip the odds in your favor when looking for a mortgage preapproval. A borrower "could have the income, but something on their credit is preventing them from being able to move forward with the mortgage," Wendland says. "If they get that out of the way first, it gives them a clear path to purchasing their home."
Here are a few ways to clear the path for yourself:
Fix errors on your credit report. Credit reports aren't perfect, and errors that affect your score can happen. Find and fix errors on your credit report before you ask for a mortgage preapproval.
Pay down debt. Debt can hurt your credit and is a factor in the loan amount you can be approved for. Eliminating as much debt as possible can put you in a better position for mortgage preapproval.
Pad your savings account. Financial emergencies can happen to anyone without warning. Saving is a sound move for your finances, but it will also make you a better loan candidate in the eyes of the lender.
Tuck away at least three months' worth of mortgage payments to help you address financial emergencies without going into debt. And if you can save up to six months' worth of all your monthly expenses, such as your mortgage, car payment, groceries and utilities, it's even better in the long run.