When a buyer begins their search for a home, it is recommended that they stop by their lender and obtain a pre-approval. Even if this isn't his or her first rodeo, many rules have changed and options are different than they once were. Once this is accomplished and they find the home they wish to purchase, the seller will expect a pre-approval letter to be presented with the offer.
The reasoning behind this speaks to the definition of a buyer. A buyer is someone who is ready, willing, and able to purchase a home. The ready and willing part is normally not a problem. It is the able part where the hair splitting begins. Many people believe that they are able, based on what they pay in rent, how much they have to put down, etc.-but when they run their financials by a lender, they find out they aren't. A seller doesn't want to take his or her home off the market and lose market time unless the buyer has a pretty good idea that they really can complete the transaction.
There are three stages of review when a lender is working with a buyer. The first is pre-qualification. What pre-qualification entails is the borrower telling the lender about his financial readiness to buy. So for instance they may say they make $40,000 per year, have $5000 in the bank and have worked for company XYZ for three years, and their consumer debt payments are $250 per month. They may inform the lender that they have gone onto freecreditscore.com and retrieved their credit and it was 687. On the surface of it, this looks like someone who can buy a house. But what do we really know? All we know is what this individual has told us-there is no verification of any type to be sure this is true. The details we don't know such as are there student loans that aren't in repayment, or is his income commission based, or what the other two credit scores are can sink this buyer. So a pre-qualification isn't what is needed to secure an offer.
The second and most common document attesting to a borrower's ability to obtain financing is the pre-approval. In this case the lender obtains all the info the buyer has to give, plus pulls a credit report to verify that the credit is substantial enough for the loan. Normally when I issue a pre-approval I like to see a pay stub with year to date income on it as well-sometimes buyers don't calculate income the same way a lender does. If I can get them, I like to obtain bank statements and get some background on employment, and rental history as well. If I have that information I can upload it to Fannie Mae and get an automated approval. By that time in most cases, I have enough information to assess the situation and figure out where the stumbling blocks, if any, may pop up. Most of the time, this is good enough-but it is not fool proof.
Like an onion, people's financial and credit history can unpeel in endless layers of information. Once in while there is something at some level that could not have been sussed out prior to issuing the pre-approval. One such instance was a pre-approval that was done for a client who had 7 years at the same job. The pre-approval was based on income on hourly pay plus overtime which was received on a routine basis. What we didn't know, and had no reason to ask, was if there had been any interruptions in the client's job time. As it happens there was-he had quit the company for a two week period ten months prior. The rules of lending are that overtime can't be counted in income unless it has been received continuously for two years. That brief break in employment set the clock back on this client and we were not allowed to count his overtime. Had his employer not noted the interruption, or had they bridged the dates there would have been no issue-as it was, his income was not adequate for the home he purchased since the overtime could not be used.
The only sure thing in the evaluation of a borrower in our arsenal is to actually credit underwrite the buyer. Not every lender offers this service, as it is not a sure thing that the buyer will end up buying or that if they do, that they will use the lender that credit approved them. Time being money, many lenders don't want to burn the underwriting time and payroll to evaluate loans at this undetermined stage. However, if the lender will do the credit approval, this is the next best thing to a cash offer. The process is identical to a loan application only there is no property attached. When I do a "to be determined" loan, I normally use the highest loan amount that the buyer qualifies for based upon either their payment comfort zone or their debt ratio. Typically this is a feature that is good if there are any questions about the buyer's qualifications or if there may be an impediment to financing. It is always preferable to problem solve prior to the purchase agreement rather than on the fly after. The results are normally much better.
In conclusion, I only use pre-qualifications on a generic basis for hypothetical situations with a buyer who isn't ready to make a firm decision about whether or not they wish to buy a home. I won't issue a pre-approval letter until I have a credit report, and a comfort level with income. If I have any questions, I try to actually submit a file prior to purchase, at which point I can issue a credit approval letter. This gives all parties to the transaction the benefit of the best chances of a successful closing.
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