As you search for a home, getting pre-approved for a mortgage can be an important step to take. Consulting with a lender and obtaining a pre-approval letter provides you with the opportunity to discuss loan options and budgeting with the lender; this step can serve to clarify your total house-hunting budget and the monthly mortgage payment you can afford.
As a borrower, it’s important to know what a mortgage pre-approval does (and doesn’t do), and how to boost your chances of getting one.
- Going through the pre-approval process with several lenders allows a home buyer to shop mortgage rates and find the best deal.
- A seller often wants to see a mortgage pre-approval letter and, in some cases, proof of funds to show that a buyer is serious.
- The first step is filling out a mortgage application and supplying your Social Security number so the lender can do a credit check on you.
- You’ll also need to provide extensive documentation of job history, assets and liabilities, income tax returns, and more. Self-employed buyers may need to provide additional documentation.
- After reviewing your application, a lender will offer pre-approval or pre-approval with conditions, or deny pre-approval.
Pre-Approval Is a « Physical Exam » for Your Finances
Before lenders decide to pre-approve you for a mortgage, they will look at several key factors:
- Your credit history
- Credit score
- Debt-to-income ratio
- Employment history
- Assets and liabilities
Think of a mortgage pre-approval as a physical exam for your finances. Lenders will likely poke and prod into all corners of your financial life as a way of trying to ensure you’ll repay your mortgage.
Prequalification vs. Pre-Approval
You’ve likely heard the term « prequalification » used interchangeably with pre-approval, but they are not the same. With a prequalification, you provide an overview of your finances, income, and debts to a mortgage lender. The mortgage lender then gives you an estimated loan amount.
In this way, a mortgage prequalification can be useful as an estimate of how much you can afford to spend on a home. However, the lender doesn’t pull your credit reports or verify your financial information. Accordingly, prequalification is a helpful starting point to determine what you can afford but carries no weight when you make offers.
A pre-approval, on the other hand, involves filling out a mortgage application and providing your Social Security number so that a lender can do a hard credit check. A hard credit check is triggered when you apply for a mortgage. For this process, a lender pulls your credit report and credit score to assess your creditworthiness before deciding to lend you money. These checks are recorded on your credit report and can impact your credit score.
By contrast, a soft credit check occurs when you pull your credit yourself, or when a credit card company or lender pre-approves you for an offer without your asking. Soft credit checks do not impact your credit score.
Also, you’ll list all of your bank account information, assets, debts, income and employment history, past addresses, and other critical details for a lender to verify. The reason for this is that, above all, a lender wants to ensure you can repay your loan. Lenders also use the provided information to calculate your debt-to-income (DTI) and loan-to-value (LTV) ratios, which are essential factors in determining the interest rate and ideal loan type.
All of this makes a pre-approval much more valuable than a prequalification. It means the lender has checked your credit and verified the documentation to approve a specific loan amount. Final loan approval occurs when you have an appraisal done and the loan is applied to a property.
When to Get a Pre-Approval
Mortgage pre-approval letters are typically valid for 60 to 90 days. Lenders put an expiration date on these letters because your finances and credit profile could change. When a pre-approval expires, you’ll have to fill out a new mortgage application and submit updated paperwork to get another one.
If you’re just starting to think about buying a home and suspect you might have some difficulty getting a mortgage, going through the pre-approval process can help you identify credit issues—and potentially give you time to address them.
Seeking pre-approval six months to one year in advance of a serious home search puts you in a stronger position to improve your overall credit profile. You’ll also have more time to save money for a down payment and closing costs.
When you are ready to make offers, a seller often wants to see a mortgage pre-approval and, in some cases, proof of funds to show that you’re a serious buyer. In many hot housing markets, sellers have an advantage because of intense buyer demand and a limited number of homes for sale; they may be less likely to consider offers without pre-approval letters.
The Pre-Approval Process
Applying for a mortgage can be exciting, nerve-wracking, and confusing. Some online lenders can pre-approve you within hours, while other lenders can take several days. The timeline depends on the lender and the complexity of your finances.
For starters, you’ll fill out a mortgage application. You’ll include your identifying information, as well as your Social Security number so that the lender can pull your credit. Although mortgage credit checks count as a hard inquiry on your credit reports—and may impact your credit score—if you’re shopping multiple lenders in a short timeframe (usually 45 days for newer FICO scoring models), the combined credit checks count as a single inquiry.
Here’s a sample of a uniform mortgage application. If you’re applying with a spouse or other co-borrower whose income you need to qualify for the mortgage, both applicants will need to list financial and employment information. There are eight main sections of a mortgage application.
1. Type of Mortgage and Terms of the Loan
The specific loan product for which you’re applying; the loan amount; terms, such as length of time to repay the loan (amortization); and the interest rate.
2. Property Information and Purpose of the Loan
The address; legal description of the property; year built; whether the loan is for purchase, refinance, or new construction; and the intended type of residency: primary, secondary, or investment.
3. Borrower Information
Your identifying information, including full name, date of birth, Social Security number, years of school attended, marital status, number of dependents, and address history.
4. Employment Information
The name and contact information of current and previous employers (if you’ve been at your current position less than two years), dates of employment, title, and monthly income.
5. Monthly Income and Combined Housing Expense Information
A listing of your base monthly income, as well as overtime, bonuses, commissions, net rental income (if applicable), dividends or interest, and other types of monthly income such as child support or alimony.
Also, you’ll need an accounting of your monthly combined housing expenses, including rent or mortgage payments, homeowners and mortgage insurance, property taxes, and homeowner’s association dues.
6. Assets and Liabilities
A list of all bank and credit union checking and savings accounts with current balance amounts, as well as life insurance, stocks, bonds, retirement savings, and mutual funds accounts and corresponding values. You need bank statements and investment account statements to prove that you have funds for the down payment and closing costs, as well as cash reserves.
You’ll also need to list all liabilities, which include revolving charge accounts, alimony, child support, car loans, student loans, and any other outstanding debts.
7. Details of the Transaction
An overview of the key transaction details, including purchase price, loan amount, the value of improvements/repairs, estimated closing costs, buyer-paid discounts, and mortgage insurance (if applicable). (The lender will fill in much of this information.)
An inventory of any judgments, liens, past bankruptcies or foreclosures, pending lawsuits, or delinquent debts. You’ll also be asked to state whether you’re a U.S. citizen or permanent resident and whether you intend to use the home as your primary residence.
Most home sellers will be more willing to negotiate with those who have proof that they can obtain financing.
What Happens Next?
A lender is required by law to provide you with a three-page document called a loan estimate within three business days of receiving your completed mortgage application. This paperwork notes whether the mortgage has been pre-approved and outlines the loan amount, terms and type of mortgage, interest rate, estimated interest and payments, estimated closing costs (including any lender fees), an estimate of property taxes and homeowner’s insurance, and any special loan features (such as balloon payments or an early prepayment penalty). It also specifies a maximum loan amount—based on your financial picture—to help you narrow down your home-buying budget.
If you’re pre-approved for a mortgage, your loan file will eventually transfer to a loan underwriter who will verify your documentation against your mortgage application. The underwriter will also ensure you meet the borrower guidelines for the specific loan program for which you’re applying.
After submitting your mortgage application, you’ll need to gather a number of documents to verify your information. Preparation and organization on your end will help the process go more smoothly. Here’s a list of documents you need to present in order to be pre-approved or to secure final loan approval before closing:
- 60 days of bank statements
- 30 days of pay stubs
- W-2 tax returns from the previous two years
- Schedule K-1 (Form 1065) for self-employed borrowers
- Income tax returns
- Asset account statements (retirement savings, stocks, bonds, mutual funds, etc.)
- Driver’s license or U.S. passport
- Divorce papers (to use alimony or child support as qualifying income)
- Gift letter (if funding your down payment with a financial gift from a relative)
Down Payment Gifts
Many loan products allow borrowers to use a financial gift from a relative toward the down payment. If you go this route, a lender will ask you to complete a standard gift letter in which you and the gift donor aver that the gift isn’t a third-party loan with an expectation of repayment.
Otherwise, such an arrangement could increase your debt-to-income ratio and impact your final loan approval. Additionally, both you and the donor will have to provide bank statements to source the transfer of cash funds from one account to another.
Factors Impacting Pre-Approval
If you want to maximize your chances of getting a mortgage pre-approval, you need to know which factors lenders evaluate in your financial profile. They include:
Your debt-to-income (DTI) ratio measures all of your monthly debts relative to your monthly income. Lenders add up debts such as auto loans, student loans, revolving charge accounts, and other lines of credit—plus the new mortgage payment—and then divide the sum by your gross monthly income to get a percentage.
Depending on the loan type, borrowers should maintain a DTI ratio at (or below) 43% of their gross monthly income to qualify for a mortgage. The higher your DTI ratio, the more risk you pose to lenders; you could be more likely to struggle to repay your loan on top of debt payments.
Having a lower DTI ratio can qualify you for a more competitive interest rate. Before you buy a home, pay down as much debt as possible. Not only will you lower your DTI ratio, but you’ll also show lenders that you can manage debt responsibly and pay bills on time.
Loan-to-Value (LTV) Ratio
Another key metric that lenders use to evaluate you for a mortgage is your loan-to-value (LTV) ratio, which is calculated by dividing the loan amount by the home’s value. A property appraisal determines the property’s value, which might be lower or higher than the seller’s asking price. The LTV ratio formula is where your down payment comes into play.
A down payment is an upfront sum of money you pay, in cash, to the seller at the closing table. The higher your down payment, the lower your loan amount. And as a result, the lower your LTV ratio. If you put down less than 20% percent, you might be required to pay for private mortgage insurance (PMI). It’s a type of insurance coverage that protects lenders in the event you fail to repay your mortgage. To lower your LTV ratio, you either need to put more money down or buy a less expensive house.
Credit History and Score
Lenders will pull your credit reports from the three main reporting bureaus—Equifax, Experian, and Transunion. They’ll look for your payment history and whether or not you pay bills on time, how many and what type of credit lines you have open, and the length of time you’ve had those accounts.
In addition to positive payment history, lenders analyze how much of your available credit you actively use, also known as credit utilization. Maintaining a credit utilization rate at (or below) 30% helps boost your credit score. It also shows lenders a responsible, consistent pattern of paying your bills and managing debt wisely. All of these items account for your FICO score, a credit score model used by many types of lenders (including mortgage lenders).
If you have not opened credit cards or any traditional lines of credit—such as a car loan or student loan—you might have trouble getting a mortgage pre-approval. You can build your credit by opening a starter credit card with a low credit line limit and paying off your bill each month. It could take up to six months for your payment activity to be reflected in your credit score. It’s important to be patient as you build your credit profile.
Most lenders require a FICO score of 620 or higher to approve a conventional loan, and some even require that score for a Federal Housing Administration (FHA) loan. Lenders typically reserve the lowest interest rates for customers with a credit score of 760 or higher.
FHA guidelines allow approved borrowers with a score of 580 or higher to pay as little as 3.5% down. Those with lower scores must make a larger down payment. Lenders will often work with borrowers with a low, or moderately low, credit score and suggest ways to improve their score.
The chart below shows your monthly principal and interest (PI) payment on a 30-year fixed interest rate mortgage based on a range of FICO scores for three common loan amounts. (Since interest rates change often, use this FICO Loan Savings Calculator to double-check scores and rates.) Note that on a $250,000 loan, an individual with a FICO score in the lowest (620–639) range would pay $1,226 per month, while a homeowner in the highest (760–850) range would pay just $1,006 (a difference of $2,640 per year).
|Estimated Monthly Payments Based on Credit Score Ranges|
FICO score range
At today’s rates, and over the 30 years of that $250,000 loan, an individual with a FICO score in the 620–639 range would pay approximately $191,535 in interest, while a homeowner in the 760–850 range would pay $112,100 (a difference of more than $79,000 in total).
Employment and Income History
When you apply for a mortgage, lenders go to great lengths to ensure you earn a solid income and have stable employment. That’s why lenders request two years’ worth of W-2 tax forms and contact information for your employer. Essentially, lenders want to ensure that you can handle the added financial burden of a new mortgage.
You’ll also be asked to provide salary information, so a lender has evidence that you earn enough money to afford a mortgage payment and related monthly housing expenses. You’ll also have to provide 60 days (and possibly more, if you’re self-employed) of bank statements to show you have enough cash in hand for a down payment and closing costs.
Loans can be classified in two ways: conforming and non-conforming. A conforming loan adheres to certain standards set forth by government-sponsored enterprise (Fannie Mae and Freddie Mac) guidelines. Jumbo loans are the only type of loan that is non-conforming.
Some types of loans, such as HomeReady (offered by Fannie Mae) and Home Possible (offered by Freddie Mac), are designed for low-income homebuyers or first-time homebuyers. Veterans Affairs (VA) loans, which typically require no down payment, are for U.S. veterans, service members, and eligible spouses.
The chart below lists common loan types and the basic (and wide-ranging) requirements for each. In the DTI ratio column, where two figures appear, the first refers to housing-only debt and the second figure refers to all debt. Under PMI/MIP/Fee, two numbers separated by a slash (/) indicate an upfront fee followed by an annual fee (paid monthly). All mortgage loans have additional requirements not listed here.
|Requirements for Common Loan Types|
|Mortgage||Min. Down||FICO||DTI Ratio||PMI/MIP/Fee||Add’l Requirements|
|Jumbo||5%-20%||720||43%||None||Non-conforming for homes more than $548,250 ($647,200 beginning in 2022)|
|FHA 203(k)||3.5%||580||31%/43%||1.75%/0.85%||Buy plus rehab|
|VA||0%||None||41%||2.3% or 3.6%*||VA cert. of eligibility|
|USDA||0%||None||29%/41%||1%/0.50%||Rural areas only|
|HomeReady||3%||620||43%||1.50%||Low income only|
|Home Possible||3%||660||45%||1.50%||Low income only|
*The VA funding fee is 2.3% for your first loan and 3.6% for subsequent loans.
If you’re a self-employed borrower, you might be asked to provide additional documents to show a consistent income and work history of at least two years. Some documents requested may include a profit-loss statement, a business license, your accountant’s signed statement, federal tax returns, balance sheets, and bank statements for previous years (the exact amount of time depends on the lender).
Typically, self-employed borrowers need to produce tax returns from the two most recent years, in addition to all appropriate schedules.
Factors that go into approving a mortgage for a self-employed borrower include the stability of the borrower’s income, the location and nature of the borrower’s business, the demand for the product or service offered by the business, the financial strength of the business, and the ability of the business to continue generating and distributing sufficient income to enable the borrower to make the payments on the mortgage.
If your situation makes it difficult to get a traditional mortgage, there are two options geared specifically for self-employed borrowers.
1. Stated Income or Stated Asset Mortgage
This type of mortgage is based on the income you report to the lender without formal verification. Stated income loans are sometimes also called low-documentation loans because lenders will verify the sources of your income rather than the actual amount.
Self-employed persons should be prepared to provide a list of their recent clients and any other sources of cash flow, such as income-producing investments. The bank may also want a copy of IRS Form 4506 or 8821.
Form 4506 is used to request a copy of your tax return directly from the IRS, thus preventing you from submitting falsified returns to the lender. It costs $43 per return, but you may be able to request Form 4506-T for free. Form 8821 authorizes your lender to go to an IRS office and examine the forms you designate for the years you specify, free of charge.
2. No-Documentation Loan
In this type of loan, the lender will not seek to verify any of your income information, which may be a good option if your tax returns show a business loss or a very low profit. Because it is riskier for the bank to lend money to someone with an unverified income, expect your mortgage interest rate to be higher for a no-documentation loan versus a full-documentation loan.
Low- and no-documentation loans are called « Alt-A » mortgages; they fall between prime and subprime loans in terms of interest rates.
After reviewing your mortgage application, a lender will usually give you one of three decisions: pre-approved, denied outright, or pre-approved with conditions. In the third scenario, you might need to provide extra documentation or lower your DTI ratio by paying down some credit accounts to satisfy the lender’s conditions. If you are denied outright, the lender should explain exactly why and also provide you with resources on how to best tackle the problems.
In many cases, borrowers need to work on boosting their credit score and ironing out a spotty payment history. Once you know what you need to address, you can take the time and effort to improve your credit and financial health to get a better mortgage deal when you’re ready to embark on your home search. Doing so can save you significant money on mortgage pricing, and ensure you get lower interest rates and terms when shopping for different lenders.
The Pre-Approval Letter
If you are pre-approved, your lender will provide you with a pre-approval letter on an official letterhead. This official document indicates to sellers that you’re a serious buyer and verifies that you have the financial means to make good on an offer to purchase their home. Most sellers expect buyers to have a pre-approval letter and will be more willing to negotiate with those who prove that they can obtain financing.
Pre-approval letters typically include the purchase price, loan program, interest rate, loan amount, down payment amount, expiration date, and the property address. The letter is submitted with your offer; some sellers might also request to see your bank and asset statements.
Getting a pre-approval doesn’t oblige you to borrow from a specific lender. When you’re ready to make an offer, you can choose the lender that offers you the best rate and terms for your needs. Getting a pre-approval doesn’t guarantee that a lender will approve you for a mortgage, either, especially if your financial, employment, and income status change during the time between pre-approval and underwriting.
The Bottom Line
Go through the pre-approval process with several lenders as a way of shopping interest rates and finding the best deal. Again, you’ll want to shop mortgage lenders within 45 days, so all credit checks count as one hard inquiry, and there is minimum impact on your credit score. And if you’re just starting to think about homeownership, the pre-approval process can help you get your credit and finances in better shape for when the time is right.
Remember that a mortgage pre-approval doesn’t necessarily guarantee you a loan. Pre-approval letters are conditional on your financial and employment information being truthful and consistent before your loan closes. Likewise, if you fail to disclose key information—a divorce, an IRS tax lien, or some other issue—and a loan underwriter finds out about it later, you can receive a denial for your loan.