By: By Jack Guttentag
In a tight market, preapprovals are needed more than ever to establish the financial bona fides of home purchasers. Unfortunately, preapprovals have also become less reliable, especially for self-employed borrowers.
A preapproval is a statement by a lender that a prospective buyer has the income, assets, and credit to be approved for the mortgage required to purchase a house of some assumed value. The statement is an opinion, not a commitment. REALTORS® frequently recommend that prospective purchasers get preapproved so that home sellers will take them seriously.
A preapproval letter may be expressed in terms of a maximum monthly mortgage payment, a maximum loan amount, and/or a maximum ratio of loan to value. If a mortgage payment is shown, the interest rate used to calculate it may be shown, but the rate used is not guaranteed and won't be until the borrower submits a complete application and the rate is locked.
If a maximum loan is specified, it will be contingent upon an appraisal of some minimum amount. The preapproval also will be dependent upon verification of information provided by the borrower and underwriting approval of the transaction.
Borrowers need not shop for a preapproval, and they don't need more than one. Lenders offer them as a way of generating loan business, hoping that the purchaser will view the preapproval as the first step in obtaining a loan.
But the borrower is not committed to the lender providing the preapproval, anymore than the lender is committed to making a loan. Hence, when the time comes to convert the preapproval into an approval, other loan providers should be shopped as well.
A mortgage preapproval is stronger than a prequalification because preapproval includes an assessment of the borrower's credit, but prequalification does not. A preapproval is weaker than an approval, however, because the property value is preliminary and the mortgage rate is not known.
In addition, lenders may not take the same care in verifying the borrower's income or assets for a preapproval as they would for an approval.
As mortgage markets became increasingly restrictive after the financial crisis, more potential homebuyers were unable to qualify for the loans they needed. This increased the importance of preapprovals to home sellers, but it also reduced the reliability of preapprovals.
Lenders are never obligated to make a loan that does not meet their conditions, and preapprovals are so full of conditions and provisos that there is no way that they can be held to them. The problem is that the conditions have become much tougher than they had been, and especially so for self-employed borrowers, who now must run a gauntlet of rules and checks.
The bottom line for home sellers is that the reliability of preapprovals is not what they once were, especially for self-employed borrowers. The moral for self-employed borrowers with preapprovals is to avoid putting down earnest money until the preapproval has become an approval, which requires that the lender has reviewed and accepted all the documents.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania.