If you are planning on buying a home, you need to first get a mortgage preapproval. Obtaining a pre-approval letter allows you to make offers on homes since it shows sellers you’re a solid buyer and that a lender has evaluated your finances and offered you a loan for a specified amount.
7 Tips To Get a Mortgage Pre-Approval
- Income and employment history
- Know your credit score
- Debt-to-income ratio
- Loan-to-value ratio
- Gather financial documents
- Compare lenders
- Don’t start too early
Many real estate agents require a pre approval letter before they will even begin working with a potential buyer, especially in housing markets where there’s a lot of competition. However, before you begin this process, it helps to understand pre-approval requirements.
What Is a Mortgage Pre-Approval?
A mortgage pre approval letter is an essential document that all buyers need when putting in an offer on a house or when applying for a home equity loan or home equity line of credit. It essentially tells the seller that you are a serious buyer whose finances have been evaluated and approved for a home loan by a licensed lender.
A home loan officer will examine all your financial records including your taxes, credit, debts, savings, and income then pre-approve you for a certain loan amount. You can then use this letter to make an offer on a house up to this loan amount. It’s also worth noting that just because a lender approves you for a certain amount it doesn’t mean that you have to borrow that full amount. In the end, you want a mortgage payment that you're comfortable covering each month, and you can always ask that they lower the final amount on your letter.
Pre-Qualification vs Pre-Approval
A common misunderstanding people have about the home buying process is between the terms “pre-qualification” and “pre-approval.” Pre-qualification is a simpler procedure that happens earlier in the mortgage process. For pre-qualification, you will meet with a lender. After the lender has reviewed your credit report and basic financial information, you will obtain an estimate of what you’re able to borrow. A pre-qualification is helpful when you’re first starting out and want to get an idea of the price range you should look in, but it does not enable you to make offers. Most lenders will be able to pre-qualify you in a matter of hours.
A preapproval is similar to a prequalification, except you’ll have to fill out a formal mortgage application and your lender will perform a more thorough review of your finances including assessing W2s, tax returns, pay stubs, and account statements as well as completing a review of your credit history. Once this is done, they will supply you with a letter listing a loan amount you’re approved for that you can then use to make offers on homes. Pre-approval letters can take several days to procure and are typically good for 90 days.
After your offer has been accepted by a seller, you then have to lock in your mortgage with your lender. Even though your lender has pre approved you for a loan, they have not guaranteed it. If your finances have changed since you first received your preapproval letter or if there are issues with your inspection or appraisal, this may affect the final loan offer you get.
7 Tips To Get a Mortgage Pre-Approval
Working with a lender to get a mortgage pre-approval is a huge step, and it pays to be prepared. Some of these steps should begin months if not years in advance, but each one will get you closer to finding the home of your dreams.
1. Income and employment history
All lenders will want to look at your income and employment history. After all, this is a huge investment for them too and they want to make sure you’ll be able to cover your monthly payment for the life of the loan. One way they do this is by ensuring you have a steady source of income and that you have a solid employment record.
Typically, lenders will want to see that you’ve been in the same line of full-time work for at least the last two years. If you’ve had a change or break in employment, be prepared to explain this to your lender. Most lenders don’t set a specific level of income. Rather, they’ll look at your complete financial picture to get an idea of all the money coming in and going out.
2. Know your credit score
You should know your credit score going into the home buying process, as this is one of the biggest factors that lenders care about. The exact credit score you need depends on your lender, the loan program you’re applying for, and how your other finances play into it.
A good credit score can ensure you get the lowest mortgage rates, and this number is generally around 740. However, you can still obtain a loan with a much lower score in the 600s. Many people will qualify for a loan with a score as low as 620, but you’ll likely have to accept a higher interest rate. Some government-backed programs like an FHA loan or VA loan will approve borrowers with scores in the 500s.
Before you begin searching for houses, you should review your credit report and find out your score. If it’s lower than you like, start taking steps to fix it now: Pay off credit card debt, consolidate debts, or start building credit if you don’t have much. It can take several months or years to inch up your credit score, but the hard work will pay off in the end in the form of a lower mortgage rate.
3. Debt-to-income ratio
Your debt-to-income ratio (DTI) is another major aspect of your creditworthiness, and this number will be looked at along with your credit score. DTI is determined by comparing your gross monthly income to your monthly debt obligations. Debts included in this calculation are car payments, student loans, credit card debt, rents, mortgages, alimony, and child-support payments. Debts that aren’t included are recurring payments like utilities, subscriptions, groceries, or taxes. Your DTI is the ratio of how much income you bring in each month to how much you’re obligated to pay.
Like a credit score, there isn’t one set number that lenders are looking for, but you generally want your DTI to be under 43% and ideally closer to 36%. Lenders like to see that you are responsible with your money and that you have enough expendable income each month to cover unforeseen expenses. This is also a ratio that you can calculate on your own before you even meet with a lender to get an idea of your status as a borrower. If you find your DTI is fairly high, you can begin chipping away at it to better your chances of being approved for a loan.
A low DTI can also be helpful if your credit score isn’t as high as you’d like. Many lenders will balance these two numbers and one can offset the other. For example, if your DTI is 44%, but your credit score is in the high 700s and you’re able to put down 20%, you’ll likely be approved for a loan. Alternatively, if your credit score is in the mid to low 600s but your DTI is 35%, a lender will be more likely to look favorably on you as a borrower.
4. Loan-to-value ratio
The loan-to-value ratio (LTV) compares the amount of your loan with the value of your home as determined by an appraisal. For example, if you take out a loan for $300,000 and the appraised value of your home is $340,000, your LTV is 88%. The higher the LTV, the bigger the risk the lender is taking; the lower your LTV, the lower the risk for your lender. Ideally, a lender wants your LTV to be at 80% or lower which is why many lenders require mortgage insurance for any borrowers that make down payments of less than 20%. This gives them added insurance so that you won’t default on your loan. Having a low LTV can improve your chances of being approved for a loan since the lender knows there’s already substantial equity in your home.
5. Gather financial documents
You’ll need to present a lot of financial documentation to your lender, so start gathering these early. Retain physical copies, but also save pdfs of everything since most lenders allow you to digitally upload documents. At a minimum, you’ll need your past two years of tax returns including W2s, paystubs for the last month, bank statements and account numbers for the past 60 days, your past two years of employment history, and any addresses you’ve lived at in the past two years.
After your lender has reviewed these financial documents, they will likely ask you for more depending on your situation. For example, they may need to see documentation of prior bankruptcies, divorce decrees, proof of child support, proof of co-signed debt, or a business tax return if you’re self-employed. They may also ask you to explain certain items on your bank statements such as large amounts transferred in or out.
6. Compare lenders
You should always talk to more than one mortgage lender when shopping for a loan. However, you don’t want to apply with too many lenders because this can negatively affect your credit score. Start by obtaining a pre-qualification from a few lenders to get an idea of what they can offer. You may wish to formally apply for a mortgage loan with two different lenders and then compare their fee structures alongside each other. This way, you can fully understand what you’re paying for including the principal, interest, taxes and insurance, origination fee, application fee, and closing cost.
7. Don’t start too early
Because most pre-approval letters are only valid for 90 days, you only want to start the preapproval process when you have a realtor to work with and you’re prepared to submit offers on homes within the next month or two. Once you get your letter, you should begin actively looking for homes because there’s no telling how long the process will take. If you go past the 90-day mark, you will have to reapply and will likely have to re-submit current documentation.
Can a Mortgage Pre-Approval Hurt My Credit?
The short answer is yes, which is why you don’t want to start this process any earlier than necessary. However, the impact won’t be too consequential if you complete the whole pre-approval process within 45 days. Any mortgage specialist reviewing your credit report will know that this dip is due to getting approvals from multiple lenders. You should refrain from opening any new lines of credit while you are house hunting because any new credit application can ding your score.
Understanding Mortgage Pre-Approval
When you’re thinking about buying a house and are still figuring out how to get a mortgage loan, it’s a good time to look closely at your finances. Ensure you have a steady source of income and have cash reserves saved for your down payment. You should also get a copy of your credit report and calculate your DTI. These two figures will give you a good idea of what your finances will look like to a lender and you can take action now to improve them to get a better mortgage interest rate.
Only after you feel you’re ready should you contact mortgage lenders to begin the approval process. Once this begins, the ball will be rolling and you’ll be ready to start working with a real estate agent and finding your new home.
