Understanding Mortgage Approvals

Mortgage FinancingBuyers are sometimes confused about the differences among Mortgage Pre-Qualification, Mortgage Pre-Approval and final Mortgage Approval. These differences are important and need to be understood properly if you are buying a house or condo.

Mortgage Pre-Qualification – This is the first step when you are getting started on your homebuying journey. It’s a very simple process, where you give your mortgage lender some basic financial information such as income, debt and assets. The lender will then give you a rough idea as to what you can afford as well as what mortgage options are available to you. This can be done very quickly over the phone or online. While this is a good starting point, it is far from complete. The lender will not look into your credit rating and will not verify the information that you provide.

Mortgage Pre-Approval  – This involves a much more thorough evaluation of your financial situation. Your lender will verify your income, savings, assets and credit rating and then determine what home value you can afford based on the down payment that you plan to make. You may want to get pre-approved by more than one lender to compare the rates they offer, but be aware that if your credit report is accessed more than three times in a six month period, this could lower your credit rating. Ideally you should seek a pre-approval from only your top three lenders. A pre-approval will give you a very solid indication as to what you can afford and, in addition, the lender will usually ‘lock in’ a specific mortgage interest rate for up to 120 days. This will ensure that your interest rate will not be higher than the quoted rate as long as you purchase within the locked-in period, and will not prevent you from taking advantage of a lower rate.

Mortgage Approval – This is the final step in obtaining approval from a lender for a mortgage on the actual home that you are buying. It’s very important to understand that this approval depends on the lender’s evaluation of the house as well as on your ability to make the mortgage payments. This evaluation, called an appraisal, can only be done after you have signed an agreement to buy the home, and this can cause problems if the appraisal is lower than your price.

For example, if you enter into an agreement to buy a home for, say, $700,000, but the lender’s appraiser says the home is only worth $675,000, then your mortgage financing will be based on the lower number. If your down payment is large enough, this may not be a problem. Let’s say, however, that you planned to make the minimum allowable down payment on the $700,000 purchase, which would be $45,000, or 6.4%. On the appraised value of $675,000, the minimum down payment would be $32,500, or 4.8%. This is $12,500 than your planned down payment, but this would still leave you $12,500 short of making up the $25,000 difference between the $700,000 price and the $675,000 appraised value. If you cannot borrow or beg this additional amount, you will not be able to finance the purchase no matter how much you can afford in monthly payments.

Financing Conditions and Bidding Wars – The problem caused by a home being appraised at less than the purchase price can be easily solved by including a condition on financing approval in the offer to purchase. If the offer is accepted, you will have a defined period of time (usually a week) during which the lender can appraise the property and give full mortgage approval. If the appraisal is low, and it’s not possible to approve the financing, then the financing condition is not satisfied, the agreement is terminated, and the deposit is returned to you. Not great for the seller, but you are protected. Unfortunately, the market is highly competitive right now and multiple offers (AKA bidding wars) are very common. In a multiple offer situation, the seller will typically want to see an offer without any conditions, and in fact it is difficult to ‘win’ a bidding war with a conditional offer. While this is very understandable from the seller’s point-of-view, it creates a dilemma for the buyer. In order to have the winning bid, the buyer will typically have to make an unconditional offer and, even worse, the offer will almost always have to be higher than the asking price.

Facing a bidding war situation, it’s very important for the buyer to have a frank discussion with the lender as to the risks involved in making an unconditional and over-asking offer. Also, the buyer’s realtor can help by making a careful evaluation of the ‘fair market value’ of the property. The bottom line is that the buyer needs to have a backup source of funds (e.g., the Bank of Mom & Dad) in case the worst happens.