How a preapproval letter may help you buy a home

Stew Larsen
Posted by Stew Larsen
Mortgage Banking

When you start shopping for a home, someone early on in the process is bound to ask, “Are you preapproved for a mortgage?”

Young woman looking at a few letters in her hands & smiling.If the answer is “No,” then you may want to take a step back before you start home shopping. Here are some useful details to know about preapproval.

A preapproval is a letter from a lender that lets you know, and your real estate agent and the seller of a home know, what size mortgage you can afford and that you have funds for a down payment. While a preapproval letter is not a guarantee of a loan, it is a strong indication that a bank has documented your financial situation and is willing to provide the mortgage you need to buy a home.

A preapproval letter from a lender strengthens your offer. It assures the seller that you have funds for the down payment and that you have a lender willing to provide the mortgage you need to buy the home you want.

A preapproval — which will be conditional on an appraisal verifying the value of the home — goes through a lender’s underwriting process. A key piece of that process is determining a borrower’s total debt payments and total income, known as the debt-to-income ratio. As a general rule, a debt-to-income ratio of 43% or less is considered to be reasonable by the federal government’s Consumer Financial Protection Bureau (CFPB).

In the preapproval process the borrower documents income, liabilities, and assets by providing two years of tax returns along with recent paystubs and bank statements. The lender will do a credit check and verify the borrower has funds available for a down payment.

Don’t confuse a preapproval with a prequalification. Although some people use the terms interchangeably, typically a prequalification is an estimate of what a potential borrower can afford and is not substantiated with income and down-payment documentation.

A prequalification is generated from the borrower’s estimates of current debt payments, income, and cash available for a down payment. The borrower’s anticipated monthly payment is based on average mortgage rates available when the prequalification is generated rather than the rate the borrower is eligible for based on a credit score.

The advantage of a prequalification is that it is quick because the borrower doesn’t have to spend time gathering income and bank statements and tax documents. It provides general guidance for someone who may be just beginning the home-shopping process.

A preapproval letter indicates you are working with a lender and takes some of the worry out of the process for you and the seller.

Although it takes some time and effort to gather the information needed for a preapproval letter, you’ll likely be glad to have one when it comes time to make an offer on a home.

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