Shopping for a home may be exciting and fun, but serious homebuyers need to start the process in a lender's office, not at an open house. Most sellers expect buyers to have a pre-approval letter and will be more willing to negotiate with those who prove that they can obtain financing.
Pre-qualification vs. Pre-approval
A mortgage pre-qualification can be useful as an estimate of how much someone can afford to spend on a home, but a pre-approval is much more valuable. It means the lender has checked the potential buyer's credit and verified the documentation to approve a specific loan amount (the approval usually lasts for a particular period, such as 60 to 90 days).1
Potential buyers benefit in several ways by consulting with a lender and obtaining a pre-approval letter. First, they have an opportunity to discuss loan options and budgeting with the lender. Second, the lender will check the buyer's credit and unearth any problems. The homebuyer will also learn the maximum amount they can borrow, which will help set the price range.
Final loan approval occurs when the buyer has an appraisal done and the loan is applied to a property.
Requirements for Pre-approval
To get pre-approved for a mortgage, you'll need five things—proof of assets and income, good credit, employment verification, and other types of documentation your lender may require. Here is a detailed look at what you need to know to assemble the information below and be ready for the pre-approval process:
1. Proof of Income
Buyers generally must produce W-2 wage statements from the past two years, recent pay stubs that show income as well as year-to-date income, proof of any additional income such as alimony or bonuses, and the two most recent years' tax returns.
2. Proof of Assets
The borrower needs bank statements and investment account statements to prove that they have funds for the down payment and closing costs, as well as cash reserves.2
The down payment, expressed as a percentage of the selling price, varies by loan type. Most loans come with a requirement that the buyer purchase private mortgage insurance (PMI) or pay a mortgage insurance premium or a funding fee unless they are putting down at least 20% of the purchase price. In addition to the down payment, pre-approval is also based on the buyer's FICO credit score, debt-to-income ratio (DTI), and other factors, depending on the type of loan.
Veterans Affairs (VA) loans, which require no money down, are for U.S. veterans, service members, and not-remarried spouses. A buyer who receives money from a friend or relative to assist with the down payment may need a gift letter to prove that the funds are not a loan.
3. Good Credit
Most lenders require a FICO score of 620 or higher to approve a conventional loan, and some even require that score for a Federal Housing Administration loan.7 Lenders typically reserve the lowest interest rates for customers with a credit score of 760 or higher.8 FHA guidelines allow approved borrowers with a score of 580 or higher to pay as little as 3.5% down.
Those with lower scores must make a larger down payment. Lenders will often work with borrowers with a low or moderately low credit score and suggest ways to improve their score. There are also grants, first time buyers assistance and financial assistance programs your lender can go over with you.
4. Employment Verification
Lenders want to make sure they lend only to borrowers with stable employment. A lender will not only want to see a buyer's pay stubs but also will likely call the employer to verify employment and salary. A lender may want to contact the previous employer if a buyer recently changed jobs.
Self-employed buyers will need to provide significant additional paperwork concerning their business and income. According to Fannie Mae, factors that go into approving a mortgage for a self-employed borrower include the stability of the borrower’s income, the location and nature of the borrower’s business, the demand for the product or service offered by the business, the financial strength of the business, and the ability of the business to continue generating and distributing sufficient income to enable the borrower to make the payments on the mortgage.
Typically, self-employed borrowers need to produce at least the two most recent years' tax returns with all appropriate schedules.
The lender will need to copy the borrower's driver's license and will need the borrower's Social Security number and signature, allowing the lender to pull a credit report. Be prepared at the pre-approval session and later to provide (as quickly as possible) any additional paperwork requested by the lender.
The more cooperative you are, the smoother the mortgage process.
The Bottom Line
Consulting with a lender before the homebuying process can save a lot of heartache later. Gather paperwork before the pre-approval appointment, and definitely before you go house hunting.