Real Estate 101: The Pre-Approval and Lending Process

Real Estate 101: The Pre-Approval and Lending Process

We discussed the basic financial planning steps last blog, covering mostly your credit score and initial budget, so now let’s shift to the lending process and what you need to get pre-approval for a loan.

In this crazy market, one thing you can do to give yourself an advantage over the competition is to get pre-approved for a loan. This differs from getting pre-qualified because it involves filling out a mortgage application, providing a Social Security number, and the lender doing a hard credit check. Opposed to a soft credit check which occurs when you pull credit yourself or a credit card company pre-approves an offer, your credit can be impacted by a hard pull. 

It is suggested to get pre-approval before getting really serious about purchasing a home. Pre-approval letters, official documents that state how much your loan could be approved for, are usually good for 60-90 days. Lenders want to see your debt-to-income (DTI) and loan-to-value (LTV) ratios which are both vital factors to determine the interest rates and loan type ideal for your particular situation, but paramount is your ability to repay the loan. These letters will expire though, so be prepared to complete this process multiple times if your house hunt is taking longer than anticipated. With multiple offers going in right now, many sellers won’t even look at your offer or waste their time without a pre-approval letter. The final loan amount will be approved once your offer is accepted, an appraisal is done, and the loan itself is applied to a specific property. 

Filling Out a Mortgage Application

The first step in getting pre-approval is filling out a mortgage application. Every mortgage application has eight common sections to it: type of mortgage and terms of the loan; property information and purpose of loan; borrower’s (your) personal identifying information; employment information; monthly income and combined housing expenses; assets and liabilities; details of transaction; and declarations. 

In addition to the information above, you’ll need multiple documents after submitting your application in order to verify the information provided. Such documents can include the following: 60 days of bank statements; 30 days of pay stubs; W-2 tax returns from the previous two years; schedule K-1 (Form 1065) for self-employed borrowers*; income tax returns; asset account statements, including retirement savings, stocks, bonds, mutual funds, and the like; driver’s license or U.S. passport; divorce papers (*if needed to use alimony or child support as qualifying income); and a gift letter (*if applicable). 

Different guidelines apply for different types of loans. It is highly suggested to work with your lender and determine which type of loan would work best for your situation. There are various loans out there for first-time home buyers, for veterans, and for low-income buyers, just to name a few. The type of loan will determine how much of a down payment you’ll need to purchase the home. 

Whether or not you’ll qualify for the loan, will depend mainly on four factors. 

The 4 Cs of Evaluating Your Finances

Most lenders look for the 4 Cs when evaluating your finances and deciding whether or not to offer you a loan: capacity to pay back the loan; capital; collateral; and credit. They will also determine the fifth C: the conditions of the loan (which will depend on the type of loan you receive and vary greatly based on the factors below, so we will skip this for now). 

Quick overview of each:

• Capacity to pay back the loan- Your salary, employment history, savings, and debt all come into play here. Essentially, the lender wants to ensure that you can pay back the loan by comfortably paying your mortgage each month. (That’s the main reason for the 28% rule when establishing your budget.)

• Capital- Capital is basically all of the monies and savings plus your investments, properties, and other assets that are “reserve funds”. If necessary to help pay the loan, you could move money around and dip into these for readily available cash to pay your mortgage.

• Collateral- Lenders will take into account the value of the property you’re making an offer for and other possessions you have as security against the loan. 

• Credit- We started discussing the need for good credit, but there are a variety of factors that go into your credit score, which can affect the lending process: payment history (35% of your FICO Score, used by most lenders); amounts owed/credit utilization ratio-- keep your credit usage under at least 30%, or as low as possible (30% of your score); credit history length, or how long you’ve had accounts open-- the longer, the better (15% of your score); credit mix-- the types of accounts you have show your ability to manage a range of credit products, such as student loans, car payments, and credit card (10% of your score); and new credit-- the number of new accounts you’ve opened and hard credit checks-- generally speaking, you want to keep this low (10% of your score).

Lenders look at how much debt you’ve had in the past and essentially that you’ve paid it back in a timely manner and that you’re stable enough financially to take on a new loan. 

Ideally, your debt-to-income (DTI) ratio should be as low as possible to qualify for the most competitive interest rate, but most lenders suggest keeping DTI at or below 43% of your gross monthly income to qualify for a mortgage. 

Loan-to-value (LTV) ratio is another metric vital to lenders in evaluating you for a mortgage. This ratio is calculated by dividing the loan amount by the home’s value. This requires a property appraisal to determine the property’s value, which could be higher or lower than the seller’s asking price. Based on the LTV, you’ll want to play with different scenarios and simulations to determine your down payment, or the upfront sum of money that you’ll pay in cash at closing. Basically, the higher your down payment is, the lower the amount of your loan will be. Additionally, the LTV ratio will become lower as a result. If your down payment ends up being less than 20%, which is typical for many buyers, you’ll be required to pay for private mortgage insurance, or PMI, until that 20% of home equity is built up. PMI should be calculated into your monthly payment, along with any additional fees and taxes, like HOA fees and local property taxes. 

Finally, you should budget for 2 to 5% of your purchase price for closing costs (recording fees, appraisals, etc.). Like we mentioned earlier, working with a mortgage lender to run through various scenarios and simulations will help you determine what is best for your unique financial situation and what exactly you can afford. 

The Bottom Line

Once you’re pre-approved, you’ll have a better idea of what exactly you can afford and you can make adjustments to your initial budget. Furthermore, if you complete this process and realize that now isn’t a great time, personally, for you to purchase a home, you have a better understanding of your financial situation and can work to improve factors like credit score and DTI for down the road. 

The home buying process can become complicated quickly, but if you understand the basic facets and the process, you will be better equipped to navigate this milestone. Finding an experienced realtor and lender can make all the difference in making this a smooth, enjoyable process for you.