Preparation
The first step in this process is not contacting a realtor or real estate agent or going to open houses. Before looking for your perfect home, you must understand how much home you can afford. The phrase "how much home you can afford" has nothing to do with the home price alone. Instead, it is a holistic examination of your financial situation, including your prospective mortgage loan and potential loan payments, to determine your best path to homeownership.
One way to do this is to get a preapproval letter from a bank or mortgage lender. A preapproval letter can help you plan and budget for your new home. It also demonstrates to prospective buyers and buyer's agents that you are serious about buying a home.
The purpose of preapproval and prequalification is to determine your creditworthiness. Lenders do this by reviewing your financial history. Lenders will pull your credit report and other documents during this process. As a prospective buyer, you can use this process to help you determine if you are ready to buy a new house.
Prequalification
Many banks and mortgage lenders may offer prequalification; however, prequalification is not synonymous with preapproval. Lenders often use the prequalification process to determine a prospective homeowner's creditworthiness. Creditworthiness refers to a potential debtor's ability to repay their debts. A mortgage is a serious financial undertaking for lenders and borrowers.
Lenders take a risk with each loan they approve. Lenders often lose money if the borrower defaults on the loan and it goes into foreclosure. Prequalification helps lenders and borrowers. If a borrower is creditworthy, they can move on to preapproval. If they are not, the denial offers prospective homeowners an opportunity to improve their creditworthiness to reapply.
Some lenders offer home affordability calculators to help borrowers through this process. This is not the same as a mortgage calculator, which calculates your monthly mortgage payments using the following information:
- Loan amount (Principal)
- Mortgage interest rate
- Loan term
- Homeowners Association (HOA) dues
- Homeowner's insurance premiums
Types of Mortgage Loans
Before starting the preapproval or prequalification process, you should understand the different types of loans available. The main types of loans include the following:
- Conventional loan
- Government-backed loans (i.e., FHA, VA, USDA loans)
Conventional loan: This is a traditional loan, not backed or insured by the federal government.
FHA loans: These are government-backed loans. The Federal Housing Administration (FHA) is part of the Department of Housing and Urban Development (HUD) and offers loans backed and insured by the federal government. FHA loans often feature lower interest rates.
VA loans: These are low-interest home loans for Veterans or active members of the U.S. Military. The Department of Veterans Affairs administers VA loans for veterans or current active members of the U.S. Military.
USDA loan: This is a non-conventional loan offered by the United States Department of Agriculture to purchase a home in a rural area. The USDA offers these loans to prospective low- and middle-income buyers.
Preapproval
Once a lender prequalifies you, you can move on to the second step, which is the mortgage preapproval. Lenders will do a hard pull on your credit history and look at the following:
- Credit score
- Debt-to-income ratio (DTI ratio)
- Total monthly debt (including car loans and credit card debt)
- Recent pay stubs (at least two months)
- Recent tax returns (at least two years)
- Current bank statements (approximately two years)
Please note these are some of the basics that lenders look at in determining your creditworthiness. If prospective lenders approve your loan, they will issue a preapproval letter.
Preapproval letter
The preapproval letter should indicate the amount of credit the lender has approved. This letter will demonstrate that you are serious about buying a new home. These letters are often valid for 30 to 60 days and should indicate your credit limit so you know how much home you can afford. You can calculate the following for your mortgage loan:
- Potential upfront down payment
- Potential monthly mortgage payments
- Likely private mortgage insurance (PMI)
- Potential homeowners' insurance
- Potential mortgage rate
These letters help narrow down your choices to stay within your budget. It can help eliminate any future surprises.
Prequalification Process
Before proceeding with prequalification or preapproval, you should gather the documents and histories most lenders need to assess your creditworthiness.
Here are a few items to include:
- Your work history will show:
- Have you been steadily employed for the last two years?
- If you have recent gaps in your employment history, what caused them?
- Has your income fluctuated over the previous two years? If so, why?
- What is your annual income?
- Your credit history can:
- Check your credit report first
- Dispute any incorrect accounts with the credit reporting agencies
- Lower the balances on your credit cards
- Show if you have ever defaulted on a loan, including student loans
- Indicate that your existing accounts are current
Financial Planning
Buying a new home has many hidden costs, and a prequalification or preapproval can help you save for these costs.
A few examples of these additional costs include, but are not limited to, the following:
- Down payment
- Home inspection
- Closing costs, including realtor or real estate agent commissions
- Home appraisal, which helps determine the home's value
- The preapproval process should give you an idea of how much you should save
Get Legal Help
Although a real estate attorney cannot help you decide if you are ready to buy a new home, they help you through many aspects, including the closing process. They can review your mortgage contracts to protect your interests. If you have questions about the home-buying process, speak to a qualified real estate attorney today.
