Preapproval or Prequalification: Pros and Cons for Homebuyers
The process of obtaining a loan has changed significantly over the past few decades, brought about by everything from the number of lenders to the advent of the internet. Traditional banks are competing with brokerage firms, credit unions, and online banks (just to name a few).
Prequalification letters and preapproval letters are similar in that they both give the buyer a range of how much they can borrow, but there are key differences that affect the buyer's chances of standing out from the crowd. Learn more about what each letter represents and how Litchfield Beach home buyers can use either to their advantage.
How Prequalification Letters Work
A prequalification letter can be seen as a preliminary step to the preapproval letter. With a prequalification, buyers do not have to give detailed information regarding their income, savings, and assets. Once lenders collect the information, they may do a quick background check into the client's accounts and financial data. However, they may also arrive at their numbers based on the buyer's information. It's why prequalification letters may only take a few hours to generate. The potential lender will give an idea of how much a buyer can afford, but it's not necessarily based on anything more than the buyer's word.
How Preapproval Letters Work
A preapproval letter is much more involved process, one where a lender takes the time to collect (and verify) everything from pay stubs to W-2 forms to tax returns. Buyers will need to fill out a mortgage application and give permission for lenders to run an official credit check and thorough financial review.
By requiring this information, lenders are making buyers prove the state of their financial affairs. Once the lender has reviewed the application and assets of the buyer, they'll determine how much the buyer is approved for. This number is technically a commitment from the lender, though it is not an unconditional promise. Lenders will also give buyers the terms of the loan, including the interest rates the buyer can expect.
There are a few things to note about how preapproval letters work:
- Buyers may or may not be locked into these interest rates for a given period of time.
- The cost of a preapproval letter ranges from free to several-hundred dollars.
- A prequalification letter is not required if the buyer has a preapproval.
How to Approach the Process
A prequalification letter is usually recommended for buyers who just want to get their feet wet. It will likely be free, and it's a great way to get the conversation started about how much the buyer can afford. If the buyer is in a true buyer's market, a prequalification letter may be enough for a seller to turn their head. However, in most markets, buyers will need more.
House hunters who are serious about buying soon should go straight to a preapproval letter if they hope to compete against other buyers. Before seeking the preapproval letter, they should learn the terms of the lender's letter (e.g., cost, interest rate lockdowns, etc). One important caveat for buyers is that neither kind of letter is guaranteed. While it's less likely that a lender will back out of the loan in the case of a preapproval, it's not impossible.
Lenders may know everything there is to know about the buyer's finances in the case of a preapproval, but they don't necessarily know anything about the property. If it turns out the ex-spouse of the seller is contesting the sale of the home, the lender may reserve the right to rescind their offer until the resolution of ownership is decided. By this time, the buyer may have lost the original terms of the loan, which could cause their interest rates to change.
Other potential complications include the buyer including the closing costs in the total loan price, potentially pushing the buyer into a higher loan bracket. This can cause the lender to back out of the sale entirely. Similarly, if the home buyer loses their job between the time of their application and closing, the lender may withdraw the offer. In exceptionally rare occasions, a lender may even rescind the offer after closing.
The preapproval letter may be more valuable of the two documents from lenders, but both serve a purpose for buyers. Buyers who may not be very far along in the process don't have to go through the ordeal of gathering all their financial documents together for a preapproval letter, nor will they have to pay the price for the lender to underwrite the mortgage application. Still, it's the preapproval letter that is likely to go farther in the eyes of the seller.