Once a person has made the decision that they would like to look-into buying a new home, often their first reaction is "I better start looking at homes right away, so I can find the perfect home at the perfect price". While this is a natural reaction and is certainly an exciting part of the home purchase process, it is not the first step in finding the perfect home. The first step should be to correctly identify the price range for your perfect home.
Because most home purchases require some portion of the purchase price to be financed by a lending institution, in most cases the “correct price range” is heavily influenced by the amount a lender is willing to loan to you, and at what rate they are willing to loan this money. For this reason it is very important that you begin your "new home search" with a lender, not looking at houses for sale. While most real estate agents (including myself) are happy to spend some time with you “casually looking” at a few houses, the fact is that you cannot do very much of this without knowing the amount of money a lender will provide to you. You simply MUST know what you can borrow and how much you want to spend on a home.
Looking at homes before talking to a lender often results in burnout or failure from three main culprits;
Frustration: I have spoken to many "would-have-been” homeowners who decided not to purchase a home because they spent too much time looking at, and falling in love with homes that they could not afford. When they finally came to grips with what they could actually afford, the less expensive homes often did not have all of the exciting features of the more expensive homes the Buyer had been looking at. The buyer became frustrated and decided not to buy anything. Some real estate agents have a difficult time drawing the line between "getting a taste of the market" and allowing their client to flounder around looking at homes which they do not qualify for. The agent really is doing a disservice to their client because it can dramatically reduce the joy and happiness of homeownership.
Timing: I have also seen buyers who knew exactly how much they wanted to spend, found the perfect home at the perfect price, and then lost that home to another buyer because they could not get their financing in place fast enough. Somebody else got their perfect home at the perfect price. This problem seems more prevalent in a strong buyer's market where people often get the misconception that in a buyers market, the buyer has all the cards and doesn't need to hurry up with anything. While this is probably true for the majority of the homes in a buyers market, this is absolutely not true for the best homes at the best price. The hottest deals in any kind of market always go to the buyer who is most prepared, who can make a fast offer, and can convince the seller that their offer has the best chance to close escrow. If you want to chase “below average” deals, you can do this at your leisure. If you want HOT deals, you have to be prepared.
Unknown Problems: Most of us have very little knowledge on the nitty-gritty details of our financial history. People are often surprised to find problems with their credit report that they had no idea existed. In many cases these problems are a result of errors in the credit reporting system or minor difficulties that the person thought they had solved many years ago. Talking to a lender and qualifying for a loan before you start your home buying process will provide you with ample time to identify and solve these problems and to correct errors. If you try to solve these issues during the 17 days provided for in a typical real estate purchase contract, you will probably be unsuccessful.
For information about how to identify a good lender and what the loan approval process is like, please read my articles on these topics. For the purpose of this article I'm going to assume that you have identified a lender and have provided that lender with the information that they asked for.
Once you have met with a lender, they can provide you with many different kinds of Information about the type of loan you may qualify for. Some of this information is of no value to you at all and some of this information is very valuable. Unless you have had a conversation with your lender to the contrary, your lender should provide you with at least two of the following “valuable and informative” documents; A loan Prequalification, or a loan Pre-approval and a “Good-faith Estimate”.
A prequalification is usually a free service provided by the lender and it represents the absolute minimal information a lender can provide to you which has any value to you at all. While a prequalification is certainly not as useful as a pre-approval, it is still better than nothing at all. A prequalification is simply the lender telling you that "based on the information you provided", you "may qualify" for a loan for “X” amount. To obtain a loan prequalification, you must provide to the lender much of the information that they would require for a loan approval. This would include information about your employment, income, your assets, current debt, etc. With a prequalification, this information could be obtained simply through a telephone conversation with the lender, or through actual documents that you provide to them.
A prequalification letter is a "nonbinding" document provided by the lender. Nonbinding means that the lender is not required to provide you with a loan for the amount stated in the letter, or for that matter, any loan at all. Because it is nonbinding and because the seller of a property knows it is nonbinding, it has much less value in your negotiations with the seller.
The main problems with a loan pre-qualification are that the information which you supplied to the lender has not been" verified", and your loan application has not been through any kind of underwriting process.
Lenders are very picky about what kind of information they will accept as proof about your financial history. It is only through the verification process that every aspect of your financial history is either accepted or rejected by the lender in consideration for your loan approval. Only the information that can be verified (in ways acceptable to the lender) will count on your behalf. Verification does not normally occur as part of the pre-qualification letter, but is a part of the pre-approval process.
Even if information has been verified, it still must pass through some kind of underwriting process. During the underwriting process a computer or a person reviews all the aspects of your loan application and financial history and makes decisions about which rules should apply and what kind of information is required to qualify for a loan. It is not uncommon for the underwriter to request additional information (perhaps unique to your situation) about some particular aspect of your financial background. This information must be supplied to the lender and be acceptable to the underwriter before a loan is approved.
Without verification and underwriting the lender is not obligated to provide you with a loan. No matter what the loan officer may have promised, if they have not verified and underwritten, they have not committed.
With a loan pre-approval, your financial information is verified and your loan package has been reviewed by an underwriter. This requires the lender to pull your credit report, verify your job history, review your bank information, verify your down payment, et cetera. A loan pre-approval includes every step required to actually issue you a loan except for information specific about the property (such as property appraisal or condition). A loan pre-approval is a binding commitment on the part of the lender to issue you a loan within a certain period of time. A pre-approval can only be issued through an underwriter for the lender. With a loan pre-approval, you should always request a copy of the “Commitment letter" from the underwriter which will list any additional items the underwriter requires prior to issuance of the loan. You should read this letter and be sure it makes sense to you. If this letter says that you have to grow wings and fly before the lender will issue a loan, you may have a problem. There are often some fees associated with a loan pre-approval because the lender does have actual costs involved with creating this approval. Often these fees are refunded to you through the escrow process.
With a loan pre-approval, you are on the same basis in the market as a cash buyer and the only thing between you and the actual loan is finding the correct property. With a pre-approval, you will be able to close escrow very quickly after the property has been identified, because most of the work has already been done by the lender. This makes you very attractive to the seller of a property because loan pre-approval dramatically reduces the seller's risk of entering into escrow with a buyer who cannot complete the transaction.
A loan pre-approval will be very specific as to the amount of the loan, the interest rate, the length of the loan, closing costs and the minimum down payment required for the loan. A loan pre-approval should always be accompanied by a good-faith estimate which will provide detailed information about the costs associated with obtaining the loan.
It is not uncommon for buyers to avoid going through the extra hassle of getting a loan pre-approval before they start looking for a home they want to buy. This is unfortunate because you have to go through this “extra hassle” at some point, otherwise you cannot have a loan. What frequently happens when the buyer delays this process is that the buyer has less time to solve financial issues, and make good decisions. These buyers often end up paying a higher interest rate and pay more lender fees than they would have paid if they had gone through the effort of getting a pre-approval early in the game. You cannot avoid the hassle; all you can do is delay it.
The good-faith estimate is a document provided by the lender that details the “estimated” costs associated with obtaining a loan from that particular lender. A good-faith estimate only has value to you when it is accompanied by a prequalification or pre-approval from the lender. Unless the lender analyzed your particular financial situation, a good-faith estimate by itself is worthless.
The good-faith estimate is of no interest to the seller because it does not provide any information about your qualifications for getting a loan. When accompanied by a prequalification or pre-approval, the good-faith estimate does have valuable information for you. Of particular interest to you in the good-faith estimate is the amount of the down payment required, estimated monthly payment, and the lender's fees. Do you have the amount of this down payment in your savings account? Is the estimated monthly payment comfortable for you to make? How much are the lenders fees? How do these fees compare to other lenders?
Some good-faith estimates provide only a "lump sum" amount for closing costs which includes the lenders fees. You should ask your lender to provide detailed information about these closing costs because these fees can very widely from one lender to the next. Fees that the lender controls include credit reporting fees, origination fees, discount points, processing fees underwriting fees wire transfer fees, etc. by asking for detailed information on these fees you are better able to compare loan quotes from different lenders. When these fees are lumped into a single item “Closing Costs” you cannot make an informed decision. I have seen lenders hide all kinds of crap under this single category while at the same time grossly under-estimating other items so the total cost looks good to the borrower.
You are probably familiar with advertisements offering a ridiculously low price for a product, and at the bottom of the advertisement it says "plus shipping and handling fees". To the unwary shopper, the $2 vegetable chopper winds up costing $52 because the shipping and handling fees are exorbitant. Some lenders utilizes a similar tactic by offering what appears to be an extremely good interest rate while hiding much of their profit in the closing costs (the equivalent of shipping and handling fees). A good-faith estimate is your opportunity to discover what these fees are and compare them to similar fees with other lenders. The good-faith estimate will help you avoid paying $52 for your $2 vegetable chopper.
I have seen lenders provide "good-faith estimates" that are not attached to a loan prequalification or pre-approval. In some cases these good-faith estimates simply state the lowest best possible interest rate (only available to the few people with perfect credit) and the lowest fees that really only apply to special situations. These rates and fees would only apply in "a perfect world". In my opinion this is a dishonest way to do business because it can lead a potential borrower into significant problems. This is because most people do not live perfect lives. Demanding a prequalification or pre-approval will help you avoid predatory lending practices because it forces the lender to provide information to you which is relevant to your financial situation. I have seen people make an offer to purchase a home, only to learn that they were taken advantage of by the lender and could not really qualify for anything remotely close to the good-faith estimate that they received. In some cases, because they learn this information very late in the transaction, they feel forced to pay the lender's higher fees and get a terrible interest rate rather than lose the home.
You can avoid so many problems by contacting several lenders before you go looking for a home, going through the qualification process and getting the proper documents up front.
Once you obtain prequalification or pre-approval status from your lender, it is important that you have an agreement with your loan officer that they are willing to quickly provide you with a “customized” prequalification or pre-approval letter for a particular property.
For example, let's say you are preapproved for a loan in the amount of $550,000, but want to make an offer on a property in the amount of $475,650. You do not want to submit a pre-approval or prequalification letter to the seller stating that you are approved for a $550,000 loan. You really want a letter stating you are preapproved in the amount of $475,650. This is particularly important if the offer you're making to the seller is lower than the listed price on the property.
It won't help your negotiations with the seller to prove to them that you can afford more than you are offering! This kind of "custom letter" can sometimes be a little bit tricky if your lender is busy. Let’s say that you find a property on Sunday and want to make an offer on Monday. You need the pre-approval letter pretty fast. One way to avoid this problem is to make sure that you have signed an “Authorization to Receive and Convey Information” (ARC) form which allows your real estate agent to talk directly to your lender. After you have signed this form and given it to your lender, the lender can then talk directly to your agent about your loan. For example, if you know that Monday morning you will be very busy at work, your real estate agent may be available and willing to help secure this letter in a timely fashion. Without the ARC form in your lender’s file, the lender is prohibited by law from allowing your agent to request a copy of the pre-approval letter. Your agent won’t be able to help you get this letter unless the document is on file at the lenders office. Remember too that if there are price negotiations back and forth with the Seller, you may need more than one letter for a different amount.
I hope this helps you in understanding why you need to talk to your lender early and what kind of result you should be looking for from your lender. As always, if you have any questions or need additional information please contact me and I will do my best to answer your questions quickly and expertly.