We believe that buyers should get pre-approved for a loan before doing anything else. There are several reasons for this:
- Buyers know the maximum they can pay for a house. So they are less likely to fall seriously in love with a home they can't afford.
- Credit problems (if any) can be dealt with in advance. Sometimes credit reports contain erroneous information that impacts credit scores which can impact interest rates and borrowing ability. It takes time to correct these errors and sellers may not be willing to wait.
- There are many loan products and a variety of ways to structure financing for a home purchase. The pre-approval process allows time to evaluate, reflect on, and decide what best suits a particular buyer's needs. Time to do this can be extremely limited for non-approved buyers.
- Pre-approved buyers can close escrow more quickly than unapproved buyers can. This can be a huge advantage when there are multiple offers.
- Sellers will give more credence to offers made by pre-approved buyers than buyers who are not approved, unless of course they are cash buyers. This is critical when there are multiple offers.
- Buyers who are not aware of lender guidelines for income or source of down payment may erroneously presume their situation is acceptable to lenders.
The lowest form of pre-approval letter is a prequalification letter (PQL). PQL's can be written after a five minute phone conversation with a potential buyer. PQL's may be comforting to a buyer, but are not convincing to a seller or listing agent.
A firm pre-approval letter (PAL) can be written only after the lender has reviewed and approved the loan application and supporting documents. Supporting documents are essentially evidence of funds for down payment and reserves, income and liabilities, and credit. A firm pre-approval letter, signed by a competent representative of a reliable lender can be relied upon by the buyer, the selling agent, the seller and the listing agent. A prequalification letter cannot be relied upon.
If anyone wants certainty, they should insist on a PAL. However, it is important to know that a firm pre-approval letter will contain some conditions that must be satisfied. Prior to final loan approval, the lender must (minimally) review and approve the appraisal, the preliminary title report, and the purchase agreement. Any pre-approval letter that does not contain these conditions should be questioned.
A couple of examples will make it clear why a firm pre-approval letter must have these conditions. Will a lender make an $800,000 (80%) loan if the buyer pays $1,000,000 on a property that subsequently appraises for $950,000? Alternatively, what about a purchase contract that contains a $50,000 seller credit for the same transaction? In either event, the commitment to make an 80% loan-to-value loan will be based on the $950,000 value recognized by the lender, and the loan will be lowered to 80% that number, or $760,000.
So what happens if the pre-approval letter, which was the basis for the above offer did not contain these lender conditions? It depends on whether the buyer can come up with the extra $40,000 for down payment. If he can't, the deal falls apart and everybody suffers – the selling agent, the listing agent, the buyer, the seller and the loan agent that wrote and signed the pre-approval letter.