March 3, 2008

Home purchasers sometimes get into trouble because they are not clued into the sequence of steps involved in financing their purchase. These are qualification, pre-approval, approval and lock.

Qualification

Qualification (or "pre-qualification" as it is often called) is an opinion that your income, assets and current debts qualify you for a loan of some specified amount. The opinion may come from a lender, a Realtor, or it may be your own based on your use of an affordability calculator. Whatever the source, the opinion does not take your credit into account, and no one is committed by it.

It used to be that Realtors did a lot of qualifications, often back-of-the-envelope affairs, so that they would not waste time looking for houses in a price range the buyer could not afford. Increasingly, they ask borrowers to become pre-approved by a lender because it is more reliable than a qualification, and lenders are willing to provide it free of charge as a way of stimulating business. Home sellers have also learned to ask potential buyers for a pre-approval.

Pre-Approval

Pre-approval is a conditional commitment by a lender to make a loan prior to the identification of a specific property. On a pre-approval, unlike a qualification, the lender verifies the information you provide and checks your credit. A pre-approval will stipulate a loan amount or monthly payment, but not necessarily the loan type or the price.

The lender's commitment under a pre-approval is always conditional, but rarely are the conditions spelled out. Pre-approvals don’t have expiration dates, but some considerable time may elapse before the borrower receiving a pre-approval comes back to convert it into an approval. During that period, things can happen that cause the lender to back off. For example, the borrower’s credit deteriorates, or she loses her job. No one can reasonably expect a lender to approve a loan in those circumstances.

Less clear-cut are the impacts of adverse market changes, such as the tightening of underwriting requirements that occurred last year, on outstanding pre-approvals. If a lender has pre-approved a loan and the market changes to the point where the same loan would not now be approvable, will the lender honor its obligation? I fear that in most if not all cases, the answer is “no”. Fortunately, abrupt changes in underwriting rules occur very infrequently.

Approval

Approval is a commitment by a lender to make a loan. Unlike a pre-approval, a specific property (along with its appraised value) is identified, and the loan details are spelled out. These include the type and purpose of loan, down payment, and type of documentation. It will also include an interest rate, even though a rate is not firmly established until it is locked. The presumption underlying an approval is that the probability of closure is high – much higher than with a pre-approval.

It is not 100%, however, because borrowers sometimes drop out, and sometimes one or more of the conditions that accompany the approval are not met. Approval letters contain “Prior to Doc” and “Prior to Funding” conditions, which are checklists of nitty-gritty details that must be completed before the final documents are drawn, and before funds are disbursed. Sometimes, one of these details derails the train.

Lock

Lock is a commitment by the lender to a specified price – rate and points. Ordinarily, lenders lock at the borrower’s request, and view the borrower as being committed as well, though they don’t always communicate this very well, or at all. Since locking imposes a cost on lenders, some of them charge a nonrefundable fee which may be credited back to the borrower at closing.

I recommend that prospective home buyers qualify themselves, since they are much better positioned to know what they can afford than anyone else. Use calculator 5a on my web site.

I recommend that they get pre-approved as a way of establishing their bona fides to home sellers and Realtors. Only one pre-approval is needed, and it does not commit them to the issuing lender. It is only fair, however, to include that lender among the loan providers you shop when you have a contract to purchase and need a loan. But bear in mind that if you switch to B after being pre-approved by A, you must now be approved by B.

I recommend that when your loan is approved, you lock the price the same day, because that is when you know the price. Holding off because you expect market interest rates to decline, is a bad gamble. You don’t know how to forecast future interest rates any more than I do. Besides, unless you can monitor your rate on the lender’s web site, the market rate when you finally lock will be what the lender says it is.