Financing

The decision to buy a home is an exciting one. But before you start day dreaming about the perfect paint color for your new kitchen or designing the ultimate backyard setup for summer dinner parties, there is some important paperwork that you must first get out of the way.

Obtaining pre-approval for a home loan is the critical first step in the home purchase process. Pre-approval will ensure you have a very clear understanding of what you can afford, avoid closing cost surprises, and help you to better focus your home search. It would be incredibly disappointing to find the ideal home, only to later discover that you did not qualify for the loan you were so sure you could obtain.

For the same reason, it is very important to the seller that your offer to purchase his home is backed by pre-approval from a lender. When presented with offers, the seller is going to consider the serious and motivated buyer over the person who did not bother to get pre-approved. Lack of pre-approval could cause the entire deal to fall through at closing, so it presents a great risk to the seller. Since you are competing with other buyers for a home, you must be prepared to move quickly and to present an offer that will be taken seriously.

Below, I describe the steps involved in obtaining loan pre-approval, explain what to expect during the process, and provide tools to assist you.

Steps to Loan Pre-Approval

Before you contact any lenders, you should check your personal credit reports. Any errors on those reports can increase the cost of your loan or disqualify you completely. Checking your credit first will eliminate surprises, give you time to address any issues, and improve your chances of qualifying for the best possible loan. There are three national credit bureaus (Experian, Equifax, and TransUnion), so you should review your credit reports from all of them. To easily obtain free copies of your credit reports online, follow the directions on this Federal Trade Commission webpage: Free Credit Reports.

Your FICO credit score is based on your credit history and is used to predict your overall risk to a lender. The score ranges from 300 to 850, with a higher score representing a lower credit risk. 620 is the minimum score required by most lenders, and the median national score was 711 in 2011 (meaning 620 is not difficult to achieve). While you can purchase your FICO scores from the national credit bureaus, it really isn’t necessary. Your FICO score will most likely vary between each bureau, and lenders will consider many other factors when determining your overall risk as a borrower. Also, your lender can provide your FICO score to you after you’ve been pre-approved.

Another important point about credit is that now is not the time to make any big purchases. If you obtain loan pre-approval and then go out and purchase a shiny new car for your future driveway, you might be sorely disappointed to learn that the cost of your loan has increased or that you no longer qualify at all. Until your home purchase is complete, you should avoid any large purchases or new credit accounts that will impact your credit rating or debt ratios.

To qualify for a conventional home loan, your total monthly expenses should typically not exceed 36% of your gross monthly income and your housing expense alone should typically not exceed 28%. If you need help determining your debt ratios, please use my affordability worksheet. If your ratios are too high, you might qualify for government sponsored loans, such as FHA or VA loans, that allow for higher debt ratios and other benefits. Otherwise, you now have a clear picture of your debt ratios, and can easily determine which debts must be reduced or eliminated in order to increase your creditworthiness.

Assuming you already meet the debt ratio requirements, then the most important factor to consider is the amount you can comfortably afford to pay each month for your new home. Regardless of the amount a lender feels you can afford, you might have different plans for your money. Are you prepared to sacrifice savings, vacations, or replacing that old car for a luxury home? You might prefer to buy a more modest home so that you can retain the flexibility to do more things with your money. Determining a monthly budget that you are comfortable with will ensure that your home purchase is a positive experience for many years to come.

When determining your monthly budget, be sure to consider regular payments that you currently make and those you might expect as a new home owner. For example, if you are purchasing your first home, you might be leaving an apartment that included some utilities in the rent. As a new home owner, you can now expect to pay for all of those utilities. If you are moving from a small apartment to a three-bedroom home, then you can also expect your gas or electric bill to increase as you will now have more space to heat or cool.

Once you have determined your budget, you should have a clear idea of the maximum mortgage payment you can comfortably afford each month. You can use that number in affordability or mortgage calculators to determine the maximum purchase price and/or maximum interest rate required to keep within your planned budget. The higher the interest rate, the lower the purchase price you can afford, and vice versa. You won’t know the exact interest rate until you have been pre-approved by various lenders, but you can use the current average interest rate at this point to get a general idea of the total purchase price you can afford.

When calculating the cost of a loan, always use the annual percentage rate (APR) rather than the quoted interest rate. The APR is always higher because it includes all financing fees included in your loan. The APR is the true cost of your loan, so that is the most important number to you. Consumer credit laws were established to protect you and ensure that lenders disclose the true cost of a loan, so they are required to provide the APR for that very reason.

All lenders will require your financial documentation in order to pre-approve and finalize your loan. While the exact documentation required may vary based on your situation (e.g., assets you own), the minimum documentation required is listed below. To simplify the application process, gather all of this documentation, scan it into a single file, password protect it if possible, and you are ready to go!

– income tax returns for the last two years
– W2s for the last two years (income as reported by your employer)
– paycheck stubs for the last month
– bank statements (checking and savings) for the last month
– investment account statements (e.g., retirement funds) for the last month
– any other documentation that supports your monthly income claims (e.g., rental income statements for your investment properties)

Because the monthly statements will expire soon, be prepared to submit the most current copies of those when it is time to finalize your loan. Lenders will want to see that those accounts have not changed since pre-approval. For example, if you plan to use gift funds or a loan from your 401k as a down payment, then your lender should be made aware of that at the time you apply to avoid any surprises or disappointments at closing.

Now that you are ready to apply for loan pre-approval, you should plan to contact as many lenders as possible. Because it is expected that buyers will shop around for a home loan, don’t worry about the impact of multiple inquiries on your credit report. Inquires related to loan comparison shopping are considered one inquiry, so will have little impact on your credit score.

While shopping for a loan, keep in mind that you are not just shopping for the best interest rate and APR, but also the best service. If you encounter a lender who is unresponsive or unhelpful during this pre-sales process that is not the person you want to work with at closing. Keep shopping until you find at least two lenders with competitive rates and superior customer service skills. I suggest that you have at least two final lenders to choose from, as having options can help you to avoid unnecessary stress at closing.

The best way to find a lender is through personal referrals. While family, friends, and colleagues might be able to point you to the lender they used last, keep in mind that those people most likely don’t buy, sell or refinance homes very often. If you know somebody who is an experienced real estate investor, that person has most likely shopped around and can provide a more credible referral to you. Otherwise, your best bet is to contact an experienced real estate agent for referrals to reputable lenders. Because agents rely on quality lenders to ensure a smooth purchase process for the buyer, they have great incentive to recommend proven lenders to you. If you cannot locate a lender via personal referrals, please contact me so that I can provide a short list of lenders to help you get started.