How to Get Preapproved for a Home Loan
A home loan preapproval can help you shop for a home you can afford and give you an advantage over other buyers when you find your dream home.
Purchasing a home, especially a first home, is an exciting and overwhelming process. When most buyers first start exploring homes on the market, the cost of the homes can seem like pretend numbers—for most people, their home is the most expensive purchase they’ll ever make. At some point during your search for the right place, a real estate agent will ask you how much you can afford to spend, which raises an important question: How, exactly, do you figure out how much a bank will lend you to buy a home?
There are a number of ways to make this calculation—some very complicated, some vague and generalized. One of the easiest and most reliable ways to determine the size of mortgage you’ll qualify for is to simply ask potential lenders. Experienced in gauging the financial health of their clients, banks and mortgage lenders can take a close look at your income, debt, and credit history and tell you the maximum amount they think you can afford to borrow. This process is called preapproval or prequalification. Asking a lender for this information does not obligate you to borrow from that institution; on the contrary, it’s recommended that you follow this process for several lenders so that you can shop for the best mortgage product and the best interest rate you can find. Seeking preapproval or prequalification can also give you a leg up on negotiations when you find the right house, because a buyer with a document in hand that says a lender is ready to provide a mortgage is in a much stronger position than a buyer who hasn’t yet applied.
Preapproval vs. Prequalification
Both preapproval and prequalification will give you an idea of how much you can afford to spend on a home, and having a letter in hand from the lender will give your offers on homes a bit more credence compared to those that don’t have them.
A potential buyer is awarded preapproval for a mortgage when they have submitted proof of employment and income and given permission for a full credit check. Preapproval is given once the lender determines a potential buyer is a good candidate and will likely be granted a loan for the preapproved amount. The lender has vetted the buyer and found them to be a good risk, and so is willing to stand behind them. Preapproval letters carry a lot of weight in the real estate world, because the sellers know that a lender has already scoured the financial history of that buyer and hasn’t found problems.
Prequalification is similar to a preapproval, but it is based exclusively on information provided by the potential buyer, which may be less accurate. To prequalify for a home loan, you’ll fill out forms indicating your income, debts, and estimated credit score, but you won’t have to submit to a credit check or provide documentation of any of the information you provide. As a result, there is more wiggle room around the interest rate, and because the lender won’t be able to actually run the credit check and loan application, it’s possible that programs and incentives may disappear before the formal credit check and application are run. Prequalification will help you have an idea of how much you can afford, but it won’t hold as much sway over a seller if you make an offer.
Why Get Preapproved?
When you find a home you’d like to make an offer to buy, you’ll want to waste no time in getting your offer in. But that can mean deciding on the fly how much you can really afford, which can result in overpaying or placing yourself in the uncomfortable position of not being able to negotiate if you’re asked for slightly more than you offered. Preapproval means that at least one bank has examined your finances, run your credit, and found that they can lend you a certain amount of money, which together with your savings should give you a very accurate idea of the highest amount you can spend. Then you can adjust down and know about how much you can afford to offer fairly quickly. This can help you get your offer in ahead of others, and your offer, backed by preapproval, will be taken seriously by the sellers.
In addition, seeking preapproval allows you to shop around. Calling lenders to ask about their rates is a good way to get a feel for which lenders generally have higher or lower rates, but actual rates are tightly tied to your credit and debt-to-income ratio, so until you’ve provided that information and the lender has run your credit, they’re guessing at what your rate will ultimately be. If you apply for preapproval at three or four banks, you’ll get accurate rates and assessments of your maximum loan, so you’ll be in a position to choose the best lender for your actual loan and place an offer with confidence.
STEP 1: Check your credit score.
Much of what your lender needs to know to offer you a preapproval can be found in a credit check. Therefore, it’s important that you know what’s in your credit report before you invite a lender to look, and ideally you’ll do this well before you’re planning to buy, so you have some time to make repairs to your score if necessary. Your credit report shows the length of your credit history, so if you’re trying to clean up your history before you buy a house, it’s a good idea to leave long-standing accounts open. The report will show the last 7 years of your credit accounts, including the initial and maximum amount of credit in each account, the amount of credit you used, and the history of on-time, late, or missed payments. It will also include your address history, job history, and any liens, bankruptcies, or defaulted accounts.
Because the reporting system is not perfect, you’ll want to check for errors or inaccurate reports. Note anything that you don’t think is correct and appeal the item with the credit bureaus, providing documentation as necessary. Then check the credit score itself, a mathematical calculation that combines your credit history, length, and utilization, often called your FICO score. Most lenders require a score of 620 or higher for a traditional loan, while FHA loans may permit a slightly lower score in exchange for a higher down payment. If your score is not where you’d like it to be, you can take some steps to improve it—opening up a credit card, using it, and paying it off each month if you don’t have enough overall credit, or paying off some loans or cards, then rechecking your score 6 months later.
STEP 2: Calculate your debt-to-income ratio.
Lenders don’t want to loan too much money to borrowers whose existing debts are too large when compared to their income. Overextended borrowers are more likely to default, so this makes sense from the bank’s position. To figure out what your debt-to-income ratio (DTI) is, calculate your total gross monthly income (before taxes) and then add up your monthly debt obligations. Many banks and financial service websites offer calculators to help you include the right information. The “magic number” is 43 percent: Your total debt payments shouldn’t equal more than 43 percent of your gross monthly income. The lower your debt-to-income ratio is, the higher your lender’s faith in your ability to repay the loan will be, and you’ll often be rewarded with a lower interest rate.
STEP 3: Gather financial and personal information to prepare for a preapproval letter.
In addition to information about your credit history and debt-to-income ratio, your lenders will request a fairly significant amount of documentation about the rest of your finances. You’ll need to take time to dig these out of a file box or hunt them down online for your paperless accounts. The first thing your lender will request is at least 2 years of federal income tax filings, including your W-2 statements. This is so they can examine your income history and make sure there aren’t unexplained and sudden changes, and to make sure there are no hidden wage garnishments on your income. To support the tax forms, you’ll be expected to provide pay stubs and at least 2 months of bank statements. You’ll be asked to provide your driver’s license, your social security number or card, and proof of any additional assets that contribute to your overall financial status.
As you gather these documents, it’s important to remember that the purpose of providing this information isn’t so that the lender can judge you and your habits. While the lenders are running a business and want to lend money to people who can pay it back with interest so that they can profit, they do have your best interests at heart; they don’t want to saddle their borrowers with more debt than they can manage to pay. Lenders know that buyers can be emotional about their offers when they find “the perfect house” or overestimate how little they can live on in exchange for a house they really want—they deal with foreclosures every week on borrowers who made those mistakes. They want you to be able to make your payments because that’s how they make money, so their scrutiny of your habits and history are aimed at a good outcome for both of you.
STEP 4: Evaluate lenders to find the best one for your needs and circumstances.
Home loans aren’t one size fits all. There are actually a surprising number of loan types, and the right one for you will depend on your credit score, your debt-to-income ratio, how much you’ve saved for a down payment, the kind of home you plan to buy, and whether or not you’re willing to pay for private mortgage insurance (PMI) for a few years until you’ve built more equity in your home (a PMI protects a lender and is required with certain types of loans when the buyer’s down payment is less than 20 percent of the home’s purchase price). Different lenders will offer different products, so it’s a great idea to sit down with a few lenders to discuss what options they might have. Especially if you have special circumstances—you’re a veteran who may qualify for a VA-backed loan, you’re purchasing a home in a rural area, or you qualify for certain categories of low-income home loans— you’ll want to shop around and find several lenders you can speak with directly who are willing to talk through their loan offerings with you to help find a loan product that fits. Once you understand the programs available for your particular circumstance, you’ll be able to check with other lenders and look specifically for banks that offer those programs.
One caveat: Multiple inquiries into your credit report can have a negative effect on your credit score. When you begin to shop for a preapproval, all inquiries within 45 days of each other won’t affect your score, as it’s obvious to the credit bureaus that the inquiries are all related to the same process and that you’ll only end up with one loan—this kind of exploration doesn’t have the same impact as applying for five credit cards in the same week. That said, you’ll want to do your homework and know which lenders you’ll want to seek preapproval through so all the inquiries can be sent through within 45 days of the first inquiry.
STEP 5: Find the right time, submit your documents, and wait for a preapproval letter.
When should you apply for mortgage preapproval? You should begin collecting your documents, assessing your debt-to-income ratio, and investigating your credit score as early as possible so that you have time to correct any errors and build up your credit if necessary. You’ll want a preapproval letter in hand before you make an offer. But you don’t want to get your letter before you’re ready to start seriously looking at houses to buy: preapproval letters have expiration dates. Because credit and income status can change quickly, most preapproval letters are valid for 60 to 90 days after they are issued. If you haven’t found a house by that time, you can usually request an extension by providing updated credit and income verification. Collect your documents early, but wait until you’re just about ready to start seriously house shopping to request preapproval.
Once you’ve submitted your documents, potential lenders will assess your financial picture and issue you one of three things: a preapproval letter presented on official letterhead including the amount of the loan you’ve been approved to take, a complete denial, or an approval with conditions. If your request has been denied, the lender will usually explain why and what you need to do to improve your chances; it doesn’t mean you’ll never be able to purchase a home, but it means you’ll need to work on your credit before you try again. For a preapproval with conditions, the lender may require that you pay off some debts to improve your debt-to-income ratio or provide additional documentation of assets. Two key things to be aware of: The dollar figure on your preapproval letter doesn’t mean you must take a loan that large, and it’s also not a guarantee that you will be loaned that amount. There are some considerations that don’t come into play until you’ve chosen a house, such as the ratio between the value of the house and the amount of the loan. A preapproval does mean you can begin to seriously shop for your new home.
Buying a home is a big process full of steps that are foreign to first-time buyers. There are rules, conditions, and requirements left and right. Home loan preapproval allows you to slow down, look carefully at your finances, and see what the bank thinks you can afford—and then decide what you’re comfortable spending. These two numbers may not be the same; if your credit is very good, your bank may approve a surprisingly high number that you’re not comfortable borrowing, which is fine. The preapproval process can give you the opportunity to assess how much you’d like to spend, how much you’re willing to spend for exactly the right house, and develop a clearer picture of how that amount will affect your finances on a month-to-month basis so you can shop with the confidence that you won’t offer more than you can afford.