If you're serious about getting a mortgage, preapproval is a key step. With a mortgage preapproval, a lender will evaluate details about your income, debts and assets and check your credit. It will use that to determine whether you're preapproved and tell you the size of the mortgage you can receive. It isn't the same as formally applying for a mortgage, but if you have a preapproval letter in hand, a seller may see your offer as stronger than others without a preapproval since your lender is already on board.
A little prep work can go a long way when you're ready to ask for a preapproval. Here's what to know.
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Mortgage Preapproval vs. Prequalification
As you go through the process of getting a mortgage, 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.
"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, vice president of mortgage lending at Guaranteed Rate Affinity, an online mortgage lender. "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 amount, interest rate and other terms you might expect from the lender. A preapproval gives you a clearer sense of those terms, as it's based on a more comprehensive review.
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." It 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 the monthly mortgage payment. Although a preapproval puts you ahead of other buyers who don't have one, it's still not a commitment from the bank. On the plus side, it also doesn't bind you to that particular bank's mortgage. You can use the preapproval letter to shop around for about 30 to 60 days.
Steps to Getting a Preapproval Letter
Understanding how the mortgage preapproval process works can help you prepare your finances.
Make a plan. If you go into the homebuying process "on a whim and you don't have a goal in mind, then I think it will get a little bit sticky down the road," Davis says. Figure out how much you can afford to pay toward a loan every month before the lender makes its own recommendation.
While every lender has a different formula for determining how large of a mortgage borrowers can afford, most like to see that your combined debts, such as your new mortgage, car payment and student loans, equal less than 36% of your gross income, your income before taxes. This is known as your debt-to-income ratio. And although lenders may prefer borrowers with a 36% DTI or lower, you might be approved with a 45% DTI. However, only you will know how much you're comfortable spending every month.
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 it may not be a requirement. Most likely, you'll need to pay for closing costs, which usually come to around 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. A healthy credit history and higher credit score -- generally, one in the mid-700s or higher -- will qualify you for a better interest rate. If there's room for improvement, you can boost your credit score through several strategies, like paying down debt and focusing on making on-time payments every month. You can check your credit reports from each of the three credit bureaus for free once a year at AnnualCreditReport.com.
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 income tax returns for the previous two years
-- Bank statements for the previous two months
-- Identification, such as a driver's license
Research different lenders. It can take years or decades to pay off a mortgage, so you'll want to know the lender -- and the loan servicer, if a different company will process your payments -- are communicative and trustworthy. 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 the customer experience you receive.
Apply for a preapproval and compare offers. You can apply for preapprovals after you've used your prequalifications to narrow your options down 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 each other.
When you're ready to fill out the applications, "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, he says.
Remember, lenders will perform a hard pull on your credit during the preapproval process, which can lower your score by a few points. However, if you're shopping around and multiple lenders check your credit over a 45-day window, the credit bureaus will count these inquiries as a single credit pull.
[Read: Best FHA Loans.]
Improve Your Chances of Getting Preapproved
There are ways to tip the odds in your favor when you're looking for a mortgage preapproval. For example, Wendland says, a borrower "could have the income, but something on their credit is preventing them from being able to move forward with the mortgage. If they get that out of the way first, it gives them a clear path to purchasing their home." Here are other 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. When checking your report, look for incorrect identification information; data about someone else entirely; signs of identity fraud, such as accounts you didn't open; account status errors; and incorrect payment and balance information. You can dispute credit report errors using the Consumer Financial Protection Bureau's guidelines.
Pay down debt. Several factors go into how your credit score is calculated, including payment history and how much debt you have in credit cards and loans. Your mortgage lender can help you figure out which parts of your credit history to tackle to make you a better loan candidate. They do this by using score simulators, which show how much your credit score may improve if you pay down certain debts, Wendland says.
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.
Falling behind on your mortgage is "an extremely difficult thing to try to catch up on," Davis says. "The banks will 'fee' you to death. They'll add late fees and interest and penalties. It's a really slippery slope when you start falling behind."
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