So you call a mortgage bank and give some basic information over the phone, and you're told you are prequalified. You go to your agent and tell him you've been preapproved. A few weeks later, your home purchase offer is accepted, and you start bringing in documentation to support what you told the mortgage bank on the phone -- but your income doesn't come out quite as high, and some of the down-payment source can't be documented. The purchase turns into a debacle, accusations fly, and the experience is awful. What happened?
You were never fully approved for a mortgage loan.
The process of getting a mortgage loan approval before a property has been found is one of the most widely misunderstood parts of the home financing process -- not only among consumers, but among real-estate professionals as well. There are three common methods of providing information about a prospective homeowner's ability to get a mortgage, and each one needs to be clearly understood before any offers are made to purchase a home.
Prequalification simply involves an over-the-phone discussion about income, money in the bank, and credit scores. You may give the mortgage professional a ballpark of what you think your credit score is. You may even be sitting in the car with a realtor, about to look at a bunch of houses, when you make this call.
While this can be a good way to get an idea of how much mortgage you can obtain, it doesn't include one key step: verification. Without seeing pay stubs, W-2s, credit reports, and bank statements, the mortgage professional is relying on the most basic information to predict whether or not you'll be approved, subject to a review of all the supporting documentation.
With guidelines constantly evolving -- and with your income, credit, and savings introducing so many potential outcomes -- prequalification is the least desirable method for predicting approval for a mortgage loan.
At this point, you actually bring in some documentation and have it reviewed by a mortgage professional. This will include your most recent pay stubs and the last two years' income so there is a clear picture of how much you make, how often you make it, how long you've been making this much, and how likely it is to continue.
Statements of bank accounts and retirement accounts will be reviewed to make sure you have enough money to complete a loan, to show that the money has been there for a while, and to explain any large deposits that are not regular payroll deposits. The lender will also obtain a credit report, and you'll be asked to explain prior addresses, applications for new credit accounts, and any late payments or bumps in your credit history.
All of this information is then entered into an automated underwriting system, and at that point the system will either approve it or refer it.
A preapproval is a much better indicator that you'll get a loan than a prequalification, but there is still one big step to go: An underwriter has to review the file.
Full credit approval
Most issues that arise during a home purchase could be avoided if all potential home-buyers got fully credit-approved -- or at least met with a realtor -- before making an offer on a house.
The reason is simple: You don't want to get emotionally invested in a home until you know you can get the mortgage financing you need. And you don't know you can get that mortgage financing until an underwriter has actually reviewed all of your documents and provided a conditional loan approval, or, as it is often called, "a loan commitment." That means every aspect of your credit, income, and money in the bank has been reviewed, and you have a letter from the underwriter letting you know that. All that's left to do is to find a home.
There is also a negotiating advantage when it comes time to make offers: You already have everything but the property and contract approved, so the path to closing on a home is much shorter. As of late 2013, almost half of all homes purchased were bought with cash. Sellers and agents are aware of how hard it is to get mortgage financing right now and prefer to take a cash offer. If you notify the seller of your fully approved mortgage financing and offer to close in 30 days or less, you might find your offer gets better consideration in the negotiating game.
Final Foolish points
The problem with looking at houses before you actually have a fully approved loan is that you may be looking at more house than your current credit profile can really afford. When you see that house with the hardwood floors, the unfinished basement, and the perfect side yard for the kids to throw the frisbee around, prudent financial decision-making often yields to "We need to get this house no matter what it takes."
By getting the loan first and looking at the payment without any emotional attachment to a house, you can go to a realtor and say: "This is the loan we are approved for and the payment we are comfortable with. Please show us houses that will keep us in this payment range." You will also show that you are a serious buyer, and agents will be much happier to work with a customer who has their mortgage financing ducks in a row.