Loan Prequalification and Preapproval

Here's a critical distinction that is often misunderstood by home-buyers. Prequalification is not preapproval!

Preapproval is a much more involved process, one that requires you to submit lots of documentation and usually commits the lender to giving you a particular loan. Prequalification, on the other hand, carries no such promise from the lender, and is simply a guide to how big a loan you'll be able to get, based on verbal information you provide. Not until a later stage, when all your documentation is submitted, will the lender preapprove you—make a commitment on your loan (preapproval).

Here is the best advice I can offer homebuyers: Start the loan process early—three to six months before you envision buying a home. And don't settle for pre-qualification. Gather all the paper work you'll need, and get preapproved. Then, when you go house hunting, you'll do so in confidence, without the worry of whether you'll be able to get financing. And you'll have given yourself a powerful negotiating advantage over non preapproved buyers in the market. This is even more an advantage if you are a typical first-time homebuyer with little money to put down. But, you can capitalize on this only if you let sellers know, through the broker, that you are a mortgage-preapproved buyer.

What Size Loan Can You Afford?

The mortgage industry uses two figures in determining each borrower's loan limit—28 and 36 (referred to as 'qualifying ratios'). These ratios are not inflexible. With most lenders, if you are close to the mark, there is usually something that can be done to push your approval through. In fact at certain times it is common for lenders to use more libral ratios—33 and 38, for example, which can enable you to qualify for a significantly bigger loan. Nonetheless, let's stay with the more conventional ratios as we explore how they affect you.

The 28 is the percentage of your gross income (before payroll taxes or other usual deductions) that lenders will allow you to pay monthly toward your mortgage. Therefore, a good idea is to try to prequalify yourself before your loan hunting begins, and it's easy todo. In computing both figures, couples are allowed to combine their incomes.

Here's an example; I'll keep the math reliable and accurate, but simple:

If your monthly gross income is $2,500, your mortgage payment can be a maximum of $700 ($2,500 x 28%). But bear in mind that by 'mortgage payment' your lender means: Principal, Interest, Taxes, and Homeowner's Insurance (PITI).

Note: When the Private Mortgage Insurance (PMI) premium is payable with your mortgage, that, too, will form part of the monthly expense the qualifying ratio must cover. You will typically pay all these items together in one check. However, for simplicity, whether PMI is payable or not, let's continue to refer to your combined monthly mortgage payment as PITI.

So, back to our example: That $700 you are qualified to spend each month would have to cover all parts of PITI.

As you can see, to compute this figure you'll have to find out how much property taxes are likely to be in the neighborhood you've targeted, and the cost of homeowner's insurance. Probably the easiest way is to call a real estate broker in the selected area,explain what you are doing, and ask about local property taxes. All brokers will have this information. If the broker insists you come to his office, decline; it is too early to do that. Plus, as a general rule, I do not favor buyers being prequalified by real estate brokers' in-house mortgage services. Instead I believe you should do your own initial research then 'shop the market' for loans. And when you are ready, talk with at least three lenders (more on this later).

Here's how the figures might work for a hypothetical couple:

Combined gross incomes (monthly) $ 4,500.00

Maximum mortgage payment $ 1,260.00 ($4,500 x 28%)

Monthly property Taxes (T) 165.00

Monthly homeowner's Insurance (I) 50.00

So the combined T and I of PITI will cost $215. Now take this from the $1260 and what's left can go toward the monthly principal plus interest payment (P+I) - $1045. (Keep in mind, too, that figures here are rounded to avoid dealing in fractions and decimals; this will alter some computations very slightly.)

Naturally, the couple's next question will be: What size loan can $1,045 per month qualify them for? To answer that question we'll need to make another assumption. We'll assume 30-year fixed-rate mortgages (FRMs) are available at 8 percent. Now the question becomes: What size loan at 8 percent can be paid off with $1045 per month? If you don't have mortgage payment tables that will allow you to calculate this (I'll tell later where to get these), or if you are not mathematically inclined, any lender will instantly provide you with the answer. Here's how the couple's figures work out:

Monthly payment of $1045.00 at 8% over 30 years will pay for a loan of $142.000.

Let's take it to the next step. The couple now know the size of loan they can qualify for. Next they must consider the cash theyhave for the downpayment. We'll assume that their savings plus a recent inheritance adds up to $24,000. So their budget becomes $142,000 (loan) plus $24,000 (cash)—a total of $166,000. On the sur-face it appears they can afford a home in the $160,000-$166,000 price range. However, first they must take additional miscellaneous costs into consideration. In fact, closing costs (settlement costs) and other fees are likely to run as high as 5 to 7 percent of the loan amount. That will reduce their budget by approximately $7,000-$10,000. To be safe we'll use the higher figure, which makes their new budget approximately $156,000 ($166,000 minus $10,000).

Continuing this scenario, let's follow the couple through a hypothetical purchase (and let's give them a name: the Browns). Justbecause their budget stretches into the mid-$150,000 range, does not mean they should spend the total amount. You'll recall I advised in an earlier site that you set two budget figures: Your comfortable spending limit and your upper spending limit. The latter figure need not be the maximum you are free to spend.

Let's suppose the Browns find an ideal home listed at $158,000 but, through smart negotiation techniques learned from this book they manage to buy the home for $145,000. Here's what their situation now looks like:

Cash downpayment (10%+) $15,000

Reserve for closing costs/ etc. $ 9,000.

The couple's $24,000 isnow accounted for.

Price paid for home $145,000Less downpayment 15,000

Loan required $130,000

An 8 percent fixed-rate mortgage of $130,000 for 30 years will cost them $954 per month. (In actuality, the Browns would also have to pay a mortgage insurance fee, as their downpayment is less then 20%.)

Now we can put the four parts of the PITI together to arrive at the monthly payment:

Monthly P+I payment on $130,000 FRM $ 954 (P+I)

Monthly taxes and Insurance $ 215 (T+I)

Monthly mortgage payment $ 1169 (PITI)

You'll recall that the Browns were qualified for a monthly mortgage payment of $1260. As it turned out, they ended up witha lower payment of $1169. So, clearly, they did not commit themselves to the maximum. Had they wished, they could have bought a more expensive home, taken a bigger loan, and had a bigger repayment. However, in this hypothetical example, their finances are not stretched to the maximum, plus they got the house they wanted.

I mentioned earlier that lenders use two standard ratios in determining how much they will lend you—28 and 36. Both figures are computed the same way, with one important exception. The 36 is also a percentage, but it applies to your monthly gross income plus your long-term debts. With this ratio your PITI payment plus your long-term debts cannot exceed 36 percent of your gross income.

The Browns had a monthly gross income of $4,500. Here, 36 percent would equal $1620, which is their maximum monthly outlay allowable—for mortgage payment plus long-term debts. This $1620 must be sufficient to pay for their mortgage plus all debts which have ten or more months still to run. Typical examples of long-term debts include car loans, student loans, and other mortgages. Credit card debts, unless excessive, usually do not count. Nor do household utility bills. So, in this instance, PITI and long-term debts cannot exceed $1620, 36 percent of the couple's combined gross incomes.

All borrowers are expected to satisfy both ratios—28 and 36. Fortunately, although most lenders won't volunteer this fact, thesepercentages are not carved in stone. But they are a good guideline.Thankfully, there is some flexibility in the qualifying process, especially when lenders are greedy for market share — which is just about always.

Negotiating for the Best Loan Terms

With every lender you talk to, and with each loan you feel might be right for you, always ask the lender to trim the rate, waive some of the fees, and sweeten the terms offered.

The point here is that there are other lenders eager for your business, and the industry is, as I said earlier, extremely competitive. No serious lender who wants your business will let you walk away when there is still room to be flexible. Saving even one quarter of one point in fees on a $100,000 loan will put (keep) $250 in your wallet at closing. Plus, saving one quarter point off your loan's interest rate could easily put another $200 every year into that same wallet.After 10 years: $2,000. After 30 years: $6,000! So, emphasize that you'll be shopping aggressively for the best rate and terms—andyou'll accept nothing less!

You're likely to find that if you have a good relationship with your present bank the manager will be especially eager to keep your business. Therefore, based on your market research results, state clearly what rate and terms they will have to beat to get your mortgage business. Mention other lenders by name, better if they're the bank's competitors. And let it be known that you are fully aware that many of the typical closing costs can be reduced or waived altogether. The lender's attorney's fees and document-preparation fees are just two such fees that are often eliminated—but only for those borrowers who ask. Ask!

If you are using a broker, ask for personal assurance that the loan being offered to you is the best then available. That is, that the loan in question is overall the lowest priced loan the broker can offer for your particular circumstances, and the terms and fees can not be bettered by the lender concerned, or with another known lender.Then wait for an answer. And watch. If you are not fully convinced by the broker's response, sleep on it, and in the morning, if you are still not convinced, do some more checking. Before you commit toany loan you must be as satisfied as possible that the broker or lender is advising you in your best interest. If you are pressured tosign quickly, don't! In fact, such pressure might be the only warning sign you'll need. The market is not short of lenders!

One final tip: In your home hunting, if you plan to engage an exclusive buyer broker (a smart idea), now is the time to talk to him or her about the loan you are considering. Ask if it falls in with what the buyer broker knows is currently available. Very likely you will pick up the confirmation you need for your peace of mind, or you'llget a referral that might deliver an even better deal. The principle here is simple: Make use of the professional resources available to you. A genuine exclusive buyer broker (also known as a buyer's agent or buyer representative) is always legally committed to serving your best interests.

Downpayment and Loan-to-Value (LTV) Ratio

For many homebuyers one of the hardest challenges is to come up with the cash downpayment. Often, however, a buyer need put down as little as 5 percent of the purchase price, and take a loan for the other 95 percent. There are even loans that will allow as little as 3 percent downpayment.

But a larger downpayment has certain advantages that should not be ignored. The first is that it lowers the monthly loan repayment (P+I). Second, it establishes equity sooner (your percentage of ownership in the property). Third, when the downpayment equals or exceeds 20 percent of the home's value, you pay no private mortgage insurance (PMI) fees.

When you make a 20 percent downpayment the lender funds 80 percent of the home's value (purchase price). This is referred to as 80 percent LTV ratio. All it means is that you have 20 percent equity in the home. Had you put down just 10 percent and financed 90 per-cent of the home's value, the LTV (at the inception of the loan) would be 90 percent.

The concept of LTV is important for one particular reason. When the downpayment is less than 20 percent of the purchase price, the buyer has no option but to pay PMI. To add insult to the expense,this insurance (similar to a life insurance policy) does not cover the buyer! It protects only the lender in case you default on the loan.

What does PMI cost, and how do you pay it? The cost varies somewhat from lender to lender. Here's an example: On a 30-year loan with 10 percent down (90% LTV), some lenders require an up-front cash payment at closing, typically 0.4 percent of the loan amount, to cover the first year. On a $100,000 loan, 0.4 will mean $400. In subsequent years the PMI renewal premiums on the same loan can range from $300-$350 and are paid with the monthly pay-ment. Other lenders combine PMI in the monthly payment, from the beginning.

However, when your equity in the home reaches 20 percent through your repayments plus the home's appreciation in value,these payments should, in theory, stop. If the homeowner doesn't shout loudly, they often don't.

Caution: Be careful with how long you pay PMI premiums. Policies and payments do not automatically expire when your equity reaches 20 percent of the home's value. However, you may have the option of paying this fee separately from your mortgage payment,which gives you more control. If so, it is worth considering. Then stop paying when your equity reaches 20 percent of the home'svalue.

Note: Your lender will probably require a reappraisal of the value of your home before agreeing to cancel the PMI policy. So research well ahead of time, before you suspect you have 20 percent equity in the property.