In a tight mortgage market, pre-approvals are needed more than ever to establish the financial bona fides of home purchasers. Unfortunately, pre-approvals have also become less reliable, especially for self-employed borrowers.
What Is a Pre-Approval?
A pre-approval is a statement by a lender that a prospective buyer has the income, assets and credit to be approved for the mortgage required to purchase a house of some assumed value. The statement is an opinion, not a commitment. Realtors frequently recommend that prospective purchasers get pre-approved so that home sellers will take them seriously. Probably just as important to Realtors, they don’t want to waste time on buyers who can’t qualify for the loans needed to complete purchases.
A pre-approval letter may be expressed in terms of a maximum monthly mortgage payment, a maximum loan amount, and/or a maximum ratio of loan to value. If a mortgage payment is shown, the interest rate used to calculate it may be shown, but the rate used is not guaranteed and won’t be until the borrower submits a complete application and the rate is locked. If a maximum loan is specified, it will be contingent upon an appraisal of some minimum amount. The pre-approval will also be dependent upon verification of information provided by the borrower and underwriting approval of the transaction.
A mortgage pre-approval is stronger than a pre-qualification because pre-approval includes an assessment of the borrower’s credit and pre-qualification does not, A pre-approval is weaker than an approval, however, because the property value is preliminary and the mortgage rate is not known. In addition, lenders may not take the same care in verifying the borrower’s income or assets for a pre-approval as they would for an approval. The case cited further below is a good illustration of this.
Why Home Purchasers Seek Pre-Approvals
"My husband and I
are purchasing a home, which is not picked out yet. Our Realtor has
given us the names of four mortgage companies to work with to get
pre-approved. Should we get pre-approved by all four, or just pick out
one to work with?"
One lender is all you need, and you may or may not end up working with
that lender.
The only reason for you to obtain a pre-approval is because
the owner of the house you want to purchase is looking for
you to have one. It establishes your bona fides as a
purchaser. More than one would serve no purpose.
Selecting a lender for no other reason than that the lender
had issued you a pre-approval, would be a mistake. On the
other hand, there is no reason to exclude that lender from
your search for a loan provider. If your experience with the
pre-approval was favorable, and if you are having difficulty
making a decision among loan providers, you might want to
give the lender providing the pre-approval an edge over the
others seeking your loan.
Why Lenders Offer Pre-Approvals
Lenders offer them as a way of generating loan business, hoping that the purchaser will view the pre-approval as the first step in obtaining a loan. But the borrower is not committed to the lender providing the pre-approval, anymore than the lender is committed to making a loan.
Pre-Approvals In a Tight Mortgage Market
As mortgage markets became increasingly restrictive after the financial crisis, more potential home buyers were unable to qualify for the loans they needed. This increased the importance of pre-approvals to home sellers, but it also reduced the reliability of pre-approvals.
“We were pre-approved for the loan we needed to purchase a house. After we found the house we wanted, we paid for an appraisal, inspection and title charges, and deposited earnest money. A week before the scheduled closing, they asked for our tax returns. Just 2 days before the closing, they informed us that because the business income reported on our tax returns was 40% lower in 2009 than in 2008, they would not make the loan…Can they do that legally?”
Lenders are never obligated to make a loan that does not meet their conditions, and pre-approvals are so full of conditions and provisos that there is no way that they can be held to them. The problem is that the conditions have become much tougher than they had been, and especially so for self-employed borrowers, who now must run a gauntlet of rules and checks. See The Problem in 2010 Is Underwriting. That does not excuse the wretched business practice of the lender referred to in the quote, who waited until a week before the closing of a home purchase to examine the income of a self-employed borrower. That is inexcusable.
The bottom line for home sellers is that the reliability of pre-approvals is not what it once was, especially for self-employed borrowers. In the first version of this article, I said that "The moral for self-employed borrowers with pre-approvals is to avoid putting down earnest money until the pre-approval has become an approval..." Rick Pelleriti pointed out to me that my advice was not useful because lenders will not provide final approval until the purchase has been executed, which requires an earnest money deposit. My revised advice for self-employed purchasers is to clarify their ability to qualify for the loan they need well in advance of purchase, using a loan provider experienced in dealing with the self-employed.
