A pre-approval letter is a written statement from a lender that summarizes how much money they’ll loan to a borrower to buy a home. Pre-approval letters also stipulate the type of loan program used for the purchase. Banks or mortgage companies issue pre-approval letters, and only after they’ve gathered and verified the financial information about their client. Typical verifications include a borrower’s income, debts, and assets.
Pre-approval letters, when combined with proof of funds, make a purchase offer from a home buyer much stronger in the eyes of the person from whom they wish to buy: the seller. While a proof of funds document shows sellers that a potential buyer has enough cash on-hand to make their down payment, pre-approvals show that the buyer can finance the balance (purchase price – down payment = loan amount or balance).
Pre-approvals should not be mistaken for a pre-qualification. The former is very useful when making an offer on a home, and the latter isn’t worth the paper on which it is printed.
Pre-Qualified vs. Pre-Approved
Pre-approvals are issued only after a thorough evaluation of a borrower’s financial profile by a lending institution.
First, lenders pull a credit report to see a borrower’s track record of making payments on-time and in-full. What’s more, credit reports also show how many outstanding revolving debt payments (credit cards balances) the person still has open. Other debts, like automobile and student loans, are also considered. Credit reports roll up all of this information into a single credit score.
Broadly-used loan program like FHA and VA loans have minimum credit score requirements. Each mortgage program publishes in their guidelines that the bank’s underwriters must follow. Most loan programs have credit score cutoff of 580 if a borrower brings a large downpayment to the deal. Otherwise, 620 is the normal low score cutoff, meaning most borrowers with scores lower than that will be unable to qualify.
Loan officers also verify the borrower’s employment history and monthly income to make sure they are steady and reliable. For borrowers, changing the company for whom they work does not necessarily reduce their chances of getting a mortgage pre-approval. However, changing careers is viewed with more scrutiny.
A separate topic, but one worth mentioning here, is the debt-to-income ratio (DTI). Lenders add up all a borrower’s monthly debt payments and divide them by the borrower’s gross monthly income. The resulting number is converted to a percentage (e.g. 30%). DTI is another standard, widely-used metric specified in mortgage program guidelines. The lower the number, the better. Popular mortgage programs generally will not make loans for borrowers with a DTI higher than 43%.
Lastly, the lender will verify the borrower’s assets like their cash-on-hand in savings, checking, or investment accounts.
All of the factors outlined above are assembled, verified, and evaluated for one purpose: to determine how much a borrower can afford. The resulting document, as you might have guessed by now, is the pre-approval letter.
Pre-qualifications, on the other hand, are far less thorough; they do not take into consideration the factors outlined above. No credit report is pulled, and no income or employment verifications are made. In fact, a person can hop on a 3-minute phone call with a bank, share a little information about their income and monthly debt payments, and get a pre-qualification. As such, pre-qualifications don’t mean much. You cannot make a credible offer on a home with a pre-qualification; sellers will flat out reject the proposal.
Pre-Approval Do’s and Don’ts
Pre-Approval letters are not a contract between a home buyer and a bank. By no means is a pre-approved home buyer guaranteed anything at this stage. The final loan approval won’t take place for some time. Underwriters issue the final ‘clear to close’ approval during the escrow period, which is weeks – if not months away – from the initial pre-approval stage of the home buying process.
Borrowers who make big purchases between the time they receive their pre-approval letter and the final approval can sabotage their ability to take out a loan. Homes shoppers should be cautious during this time. Here are some things that borrowers can do that adversely impact their pre-approved loan status:
- Change careers
- Quit their job
- Take out a new loan (car, boat, student loan, etc.)
- Take out a new line of revolving debt (credit card)
Here’s the best advice for would-be home buyers: remain as financially ‘quiet’ as possible from the time you receive a pre-approval until the time you close on the home you’re trying to buy – no big purchases, no new loans, no new credit cards, etc.
It cannot be stressed strongly enough: a pre-approval letter is not a permission slip to start spending money wildly.
How to get a Pre-Approval Letter
In spite of how complicated and convoluted everything above sounds (sorry!), the mortgage process is pretty simple.
The first thing to know is that consumers can get pre-approval letters from any financial institution that originates (makes) home loans. Banks, mortgage companies, and credit unions all offer mortgage programs to their customers. These are called institutional lenders.
Other outfits, like online mortgage companies, also offer mortgages. These are called non-bank lenders because they do not take deposits (e.g., savings and checking accounts) from customers.
None is better than another. Loans come from many places in the modern world of finance. Consumers today mainly focus on getting the best interest rate, service, and – more so than ever – convenience. By an overwhelming margin, homebuyers prefer to get mortgage pre-approvals online. Of course, visiting a loan officer in-person is still an option, too.
Regardless of which type of institution you pick or whether it’s in-person or online, the process is pretty much the same. Your loan officer will start by asking for a few key documents. Here is a list of materials needed for a mortgage pre-approval:
- Photo identification such as a driver’s license or passport
- Most recent 2 months of bank statements (savings, checking, investment accounts)
- Most recent 2 years of federal tax returns
- Most recent 2 years of W-2s
- Most recent paystub that shows year-to-date earnings
With these documents on-hand, the lender pulls the borrower’s credit report. Then, the work of evaluating everything begins. Homebuyers can usually expect an answer back within hours if not a day or two depending on the complexity of the borrower’s situation. Lenders might ask self-employed home buyers for additional documentation such as their business’ profit and loss statement (P&L).
What’s in a Pre-Approval Letter?
Pre-approval letters summarize the high-level details about a loan that the lender can make to their client, the borrower. Here are the items the letter will usually contain:
- Name of lender and contact information
- Date issued (pre-approvals are typically valid for 90 days)
- Borrower(s) name
- Purchase price
- Loan amount (purchase price minus the down payment)
- Loan term (15-year, 30-year, ARM, etc.)
- Monthly payment
- Loan program (FHA, VA, Conventional are the most common)
- Property type (single-family home, condo, townhome)
Pre-approval letters usually stipulate other loan conditions such as the maximum loan-to-value and the need to re-verify all of the borrower’s income, assets, and credit obligations before final loan approval (again, this reinforces the notion that this letter is not a guarantee to lend).
Some lenders also include another document, a loan estimate (LE), that itemizes the total funds required to close. Line items include things like origination charges, a recording fee, transfer fee, prepaid items, title fees, closing fees, and additional expenses like notary fees and home warranty.
Curious what a mortgage pre-approval letter looks like? We’ve included a downloadable pre-approval letter sample. Just click the image below.