Most of us will need to secure a mortgage in order to buy a new home. You might be advised to get "prequalified" for a mortgage before you start house hunting.
But you know what? Forget mortgage prequalification. There's a better option: getting "preapproved."
Prequalification vs. preapproval
Imagine that you've found your dream home and you're ready to make an offer on it. You know that it's well within your price range and that you have the means to buy it, but the sellers don't. They know very little about you, and they may be receiving multiple bids on their home.
This is why it's smart to talk to a lender before getting serious about a home. If you make your bid as a prequalified or preapproved buyer, that can give you an edge over other bidders, suggesting to the sellers that your offer won't fall through once the mortgage process gets under way in earnest. But being prequalified and being preapproved for a mortgage are two different things, and the latter carries much more weight.
Being prequalified for a mortgage involves having a chat with a lender and offering some information, such as your earnings, your debt burden, and your credit rating. The lender then comes up with an estimate of how much you'll be able to borrow. You should then get a document from the lender that you can show sellers and their agents to let them see that you're prequalified to borrow a certain amount.
Getting preapproved for a mortgage is more involved. The lender will actually pull a copy of your credit report instead of relying on your word about your creditworthiness. And you'll likely have to provide some financial documents and proof of your income over the past few years. Armed with that, the lender can assess your financial resources and evaluate your debt-to-income ratio, getting a sense of how much you can afford to spend on mortgage payments. Being preapproved means that a lender has made a commitment to you, agreeing to lend you a certain sum. It can make you a far more attractive bidder on a home, as the preapproval indicates there's less chance that the deal will fall apart before the closing.
Note that the preapproval doesn't last indefinitely. It may hold for just a few months. So get it when you're seriously house-hunting, not when you're simply daydreaming about a new home and visiting an open house every few weeks.
How much can you afford?
Getting preapproved for a mortgage can help you compete in a bidding war.
When getting prequalified or preapproved, there's a key mistake you don't want to make: Putting too much stock in the maximum borrowing figure provided by your lender. Yes, it has meaning, and yes, it can help you snag a home. But it might also lead you to buy more house than you can afford. After all, by lending you more money, the lender makes more money, and your lender may not fully understand your entire financial situation, including the needs of your family, the security of your job, your life goals, and so on.
Therefore it's critically important for you to independently figure out how much home you can afford to buy, lest you end up buying a home with mortgage payments that put you in a budgetary bind. Remember that you need a cushion in case of financial emergencies, such as a job loss or big medical bills.
Don't rely on the conventional wisdom that you should spend no more than 25% to 30% of your gross monthly income on housing (including property taxes and insurance), as this is not a one-size-fits-all solution. Instead, crunch the numbers yourself. Add up your household expenses, such as food, utilities, transportation, insurance, travel, entertainment, auto maintenance, debt payments, contributions to savings accounts, and so on -- but exclude your rent or current mortgage. Subtract that total from your household income, and you'll get a rough idea of what you might be able to spend on housing. Don't aim to spend all of the remainder, though; you may need more money later, and buying a new home typically involves a lot of extra expenses, such as repairs, renovations, furnishings, and perhaps a new refrigerator or a membership fee at a local club. If you're selling a home in order to buy the new one, then you might need to spend money on that to get it ready for the market.
An added benefit of determining how much house you can afford is that it can make your home-shopping more efficient; you won't waste time looking at houses that are out of your price range. Armed with preapproval and a solid sense of what you can buy, you'll be able to zero in on a new home much more quickly and easily.
Finally, understand that even though mortgage preapproval is a better option than prequalification, it doesn't guarantee that you'll actually get a mortgage from that lender. The final decision will come later, from the lender's underwriter, who will take an even closer look at your financial condition, as well as at the property you want to buy. Nonetheless, preapproval is a much better alternative to prequalification if you're serious about buying a home.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.