Here’s why getting pre-approved is important. I was working with an eager client, passionate and determined to purchase her first home. After a quick chat, she was ready to immediately see 5 houses on the market. Without knowing too much about her, I was surprised at the properties that she had chosen. These were brand new luxury constructions nestled in the heart of Boston. The price tags were astounding … well over $1 million.
After many months of nudging to see a lender, she finally met with a local bank to discuss financing options. It was a sobering moment when she discovers she would barely qualify for a purchase value of $400,000!
I tell this story to all my first time buyer clients as a precautionary tale. The first step to buying a home is speaking to a lender.
What is a Pre-Approval?
A pre-approval letter is a document from a lender or a bank that verifies your creditworthiness to get a mortgage. Given that MOST buyers will need some sort of financing, I always advise clients to first consult a trusted lender.
Getting pre-approved is an important step for many reasons.
Affordability
Like our protagonist in the story above, getting pre-approved allows the bank and yourself to determine exactly how much house can you comfortably afford. Knowing how much debt you can reliably handle will guide your home searching journey, saving you time and money.
Requirements To Getting Pre-approved
The home financing process is rather complicated and invasive. The lenders will need to probe into all aspects of your lives, your bank accounts, credit cards, W2s, and more. For some couples, this may uncover secret accounts and unknown purchases, untold credit lines, etc. It’s important to learn about these requirements upfront so you can chart your journey accordingly.
Seller Confidence
Lastly, a pre-approval letter is a verification of your credit worthiness to the seller. Without this letter from an accredited institution, the seller may very easily disregard your offer. Afterall, why should they trust that this stranger will somehow come up with $500k in 1 month?
There’s no shortage of lenders, especially in hot markets like Boston and Massachusetts. The variety of lenders range from big banks like Bank of America to small credit unions. For most conventional residential loans, the terms and requirements are rather very very similar. Since the 2008 mortgage crises, the government has put in place tight regulatory measures. As such, most conventional loans are very boilerplate and very much standardized.
Here are some key points to consider while getting pre-approved:
Interest Rates
The interest rate is what the bank will charge you to lend you the money required to purchase your property. While you may get a general estimate on the rate, the specific interest rate is unique to every buyer.
Approximate Closing Cost
The lenders will often charge a fee associated with the closing of your loan. This may include expenses such as loan origination fees, title insurance, appraisal fees, prorated home insurance, utilities, recording fees and much more. First time buyers in Massachusetts should ask for an estimate of these expenses from their lenders.
Down Payment and LTV (Loan-to-Value Ratio)
Your down payment is the amount of money you pay directly to the seller. As an example, if your purchase price is $500k, a 20% down payment would be $100k. You have to come up with $100k for the purchase and the bank will cover the rest of the $400k. In this example, the LTV would be 80% since the bank will be covering 80% of the purchase price. The down payment that you ultimately select should make sense for your financial situation. A smaller down payment means that the banks will take on more risk and they will generally charge you a higher rates, fees (such as mortgage insurance), monthly payment as a result. Conversely, the higher the down payment, rates and monthly payments will be lower accordingly. Check out this mortgage calculator to see where your sweet spot is.
Credit Score While Getting Pre-Approved
Your FICO (learn more about FICO score here) credit score is a measure of your credit worthiness. This value is based on a number of factors including your debt, credit lines, delinquencies, and overall ability to repay your loans. High credit scores can lower your rate while very low scores may adversely affect your ability to finance your property.
Debt-to-Income Ratio (DTI)
A critical factor that measures your ability to afford a mortgage is the Debt-to-Income ratio or DTI. As the name suggests, it’s the ratio of your total debt over your gross monthly income. Different lenders may have different thresholds but a good rule of thumb would cap your DTI at 45%. That is, your monthly debt cannot exceed 45% of your gross monthly income. Having this in mind, you should do some calculations to see just exactly how much down payment and housing price you can afford. Check out our mortgage calculator on our site to learn more.
Terms (Duration)
The terms of the mortgage defines essentially how much time you have to repay your loan and interest. [insert amortization chart] While the terms can technically be of any durations, the most common options are 15 and 30 year conventional loans. Longer terms mean small monthly payments but higher interest rates. The opposite is true for shorter term loans.
Gifts, Taxes, and International Transfers
If you are considering a gift or help from friends and family with the down payment, there are some key considerations. You may not have to pay taxes on monetary gifts from parents up to a certain amount (check this link to learn more). However, there are still reporting requirements. If your parents are transferring you money from overseas, consider taxes and international monetary transfer limitations. In most cases, we highly recommend the buyers to prepare the down payment in their checking account WELL before they are ready to make an offer. To learn more about international gift transfers, check out this article on Large Money Transfer Laws. Lastly, consult an accountant for tax questions.
The pre-approval process prepares you for a major milestone so take great care in finding a good lender. Shop around speak with reputable banks and loan officers. While the financing solutions may vary slightly, the backing of a seasoned and responsive lender can make a huge difference in your successful home purchasing journey. Good luck and reach out to learn more about purchasing your first home!
