As buyers begin the process of purchasing a home, in the earlier stages a pre-approval letter is the most crucial one. A mortgage pre-approval letter is an official document that proves to sellers that you're a serious buyer and also shows an estimate of how much you can afford or borrow on a loan to purchase a house. A lender will verify and review documents such as employee history, assets, debt, income report, and most importantly your credit report.
Understanding Pre-Qualification vs. Pre-Approval
A Mortgage Pre-Qualification is a quick and general loan estimate of how much a potential homebuyer may afford to acquire a home. It will likely not affect their credit scores and tax information may not be required. Lenders may require quick credit check, income information, how much you would like to borrow, and a desired down payment amount. Pre-Qualification letters are not guaranteed and also means nothing to sellers. A Mortgage Pre-Approval on the other hand, is an official letter from a lender that shows how much of a loan you can qualify for. The Pre-approval letter allows you to shop for home and it indicates to sellers that you're a serious buyer. During the pre-approval application lenders will request copies of pay stubs for the past 30 days, identification, credit check, 2-3 months of bank statements, down payment with preferred mortgage amount, and W-2 tax returns from the previous two years.
Homebuyer Tip:
When you shop around for multiple mortgage lenders to get the best deal, do it within a 45 day window so it will count as one hard inquiry.
How long does Pre-Qualification and Pre-Approval take?
Pre-Qualification usually takes up to an hour to complete and can also be done online. Potential homebuyers may receive a Pre-Approval letter within 10 business days and is typically valid between 60-90 days.
Homebuyer Tip:
Use up to 80%-90% of what you're qualified for. Spend what you can afford.
How to Get the Pre-Approval Process Ready
If you want to increase your chances of receiving a pre-approval letter and more purchasing power, factors such as credit score, DTI (Debt to Income), LTV (Loan to Value), and employment history will all play a role.
Credit Score will be checked for creditworthiness. Experian, Transunion, and Equifax will all be pulled my lenders to verify payment history, how many credit lines you have open, and overall history with your credit. Pay close attention to your FICO score as lenders view it as the most accurate reporting.
Debt to Income (DTI) ratio measures all of your monthly debts divided by your total monthly gross income. For example, after adding your monthly car expenses, utility bills, student loans and the new mortgage payment will all total to $1,800. Let's say your monthly gross income is $4,000 month. You will have a DTI ratio of 45% (1800/4000). It's important to keep this ratio low so lenders don't think you pose a risk. Lenders prefer to work with 43% and below.
Loan to Value (LTV) ratio is what lenders use to determined how much of a risk they are taking on a loan with the borrower. The amount of your down payment affects this ratio. To calculate LTV simply (Amount owed of the loan ÷ Appraised value of home) × 100. For example, a property you'll like to purchase is appraised for $200,000 and you decided to put $20,000 down. So your loan amount will be $180,000 ($200,000-$20,000). 180,000/200,000 will result in 90% LTV ratio. With a conventional mortgage 80% LTV would be best and 96.5% LTV for FHA loans.
Employment History is also an important factor as lenders will go far as back to two years of W-2 tax forms. Lenders want to see if you can afford a new hefty payment in your life and will contact employers for verification of employment. It may indicate a red flag to lenders if you bounce from job to job in different industries. Lenders may think you're not consistent and can't keep a stable job.
Recap
The importance of a pre-approval letter is critical especially in a competitive market as sellers will not take any buyers serious without one. The pre-approval letter indicates to sellers that a buyer went to a lender and verified credit scores, employment, tax information, and bank statements to come up with an estimate of how much the buyer can borrow for a home.
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