Buying a house for the first time can be very intimidating. If you are anything like I was, you may wonder if you really can take on such a huge endeavor. This is by the far the biggest investment you will ever make – a debt most likely bigger than any student loans you may have taken on. But one of the first steps and easiest ways to prove you can do this is obtaining pre-approval from a lender.
So what exactly is this all-important letter and how can it give you peace of mind? Keep reading.
Quite simply, a mortgage pre-approval letter is a letter from a lender stating that you (the home buyer) are pre-qualified for a mortgage up to a certain amount. The reason this letter is first, to show you how much you qualify for, giving you a budget for your house hunting. But most importantly it shows realtors and sellers that you have the necessary funds to afford the house you are interested in. In today's super-competitive market, you won't be taken seriously without it, and you could lose out on properties waiting to get one after you have found a house you love.
With the current housing shortage, there have been fewer homes than people — which means, that homes in desirable areas are flying off the market relatively quickly. According to a recent study by Freddie Mac, there would need to be an additional 2.5 million housing units created to make up for the current shortage. Since that’s unlikely to happen, it’s important to do everything you can to give yourself an advantage over other buyers. Getting a pre-approval letter is one of those things, as it firmly places you in the mind of the seller as a serious buyer.
While you won’t necessarily need a pre-approval immediately, it’s a good idea to have one ready by the time you’re starting to make offers on a home. Since this process tends to happen rather quickly once you find a home you like, it’s a good idea to have your pre-approval ready beforehand.
Why you need it
As I mentioned, getting pre-approved is important because it signals to the seller that you’re a serious buyer. Unless you happen to have enough cash to cover the cost (and are prepared to make a cash offer on your home), pre-approval letters act as a kind of financial guarantee to the seller that you can actually afford their house. Not only will this letter give you an advantage over other buyers when making an official offer, but it will also give you more credibility with real estate agents. Some seller’s agents may not even want to show a house without one, and your agent will be able to get you in the door of certain houses a lot faster with a letter.
Without getting preapproved, you’re very unlikely to secure a contract with any seller, especially in today’s competitive seller’s market. In the current market that has more buyers than homes, you’ll want to do everything you can to stick out as a qualified, capable buyer. By getting a pre-approval letter from a trusted bank or lender, you’re showing the seller that you’ve already gone the extra mile to ensure you can buy their house.
How to get pre-approved
The approval process for your letter will be a lot like the process of completing a mortgage application, but much shorter. To get pre-approved for a home loan to buy your dream house, you’ll first have to reach out to a lender. While you can choose a lender you intend to work with later for your actual mortgage, you’re also not under any obligation to get a mortgage from the lender who gives you the letter.
Whatever lender or bank you choose to work with will have a similar pre-approval process that involves checking your borrower profile — how much money you earn, how much you owe, and what your credit score is. This means a credit report check. This is important to understand for two reasons.
Your creditworthiness will be under serious scrutiny as a first-time homebuyer. Before you even begin with pre-approval, check your credit reports yourself with all three major credit bureaus. (You are allowed one free report from each one annually.) You'll want to clean up your report, which means disputing any errors and discrepancies to get the best FICO Score. Once this has been done, and only then, talk to a lender about pre-approval.
In addition to checking your credit score, lenders will also look at something called your debt-to-income (DTI) ratio. This is a number that’s calculated by adding up all your monthly debt payments and dividing them by your gross monthly income. Lenders typically like to see a debt-to-income ratio that’s below 43% — this ensures you actually have the income leftover to take on new debt in addition to any bills you’re already paying. The way a lender will determine your DTI is by looking at pay stubs, tax returns, and even possibly things like your credit card statements.
If you determine your DTI is above 43%, this isn't the time to seek pre-approval but rather the time to start lowering your debt and saving money. Move on to No. 1 when it's lower than 43%.
When pulling your credit report, the lender will likely perform what’s called a hard credit inquiry. This type of credit check may result in a slight drop in your credit score immediately after, which is why it’s worth knowing about. Since pre-approval letters tend to be good for several weeks or months after being written up by a lender, that dip in credit shouldn’t affect your ability to buy your dream house too much. But what it does mean is that you do not want to go to multiple lenders and apply for pre-approval to see which offers the best amount. Do this once.
Besides providing all of these different types of documentation, you’ll also need to figure out a loan amount, ie. how much of a mortgage loan you want to ask for. This starts by determining how much of a down payment you can afford to contribute, and how much you can afford to spend on a mortgage each month. Mortgage calculators can be hugely helpful when trying to come up with your desired loan amount. Just remember to calculate your mortgage budget before visiting too many homes. The reason for this is you’ll want to have an understanding of how much house you can afford to ensure you’re viewing homes that are within your budget — homes that you will be comfortable paying for every month.
As I mentioned, your creditworthiness will be established. The better the score, the best interest rate you'll qualify for. Sure, this is just the pre-approval steps but you should understand what your interest rates will be, as this will affect how much you pay each month and over the terms of your loan.
MyFico.com offers a mortgage calculator that highlights the annual percentage rate (APR) to give you an example of your monthly payments and how much interest you will pay.
Here is an example of a $300,000 30-year fixed rate, depending on your FICO score.
If you are thinking about switching jobs, you may want to hold out until after you buy a home. You'll need to show W-2s from the past 2 years, as well as current W2s, the past two years' tax returns, and proof of any additional income. When you get to the actual mortgage process, you will need to show bank statements so you need to show everything. The longer you have been employed, the better – and you'll need to provide proof of employment too.
If you are self-employed, you'll have a few hoops to jump through to prove you have averaged a consistent income level and will continue to do so.
Proof of Assets
It is recommended a buyer have a 10% to 20% down payment for a house and you will need to show evidence of this. For a $300,000 house, that is $30,000 to $60,000, which is a lot for first-time homebuyers, which is why a Federal Housing Authority (FHA) loan may be an option. These require a 3% down payment, which you still need to prove. On top of this, you'll need closing costs so have your savings on full display.
If you do not have a 10% down payment, by the way, you will have to have private mortgage insurance (PMI), which gives the lender a level of trust in loaning you $300,000. This fee is added to your monthly mortgage payment for 3 to 5 years until you reach 20% off the original mortgage. Expect this to range between 0.30% and 1.15% of the loan.
Some online lenders can provide quotes and pre-approval letters so you can do it all online. A few of these include:
If you have a minimum credit score of 620, you'll find 30- and 15-year fixed loans. You can pay as little as 3% down payment but your DTI ratio cannot be higher than 50% and you need 2% to 6% of the price for closing costs.
Owned by Quicken Loans, you'll find similar requirements but often lower rates than Quicken unless you go for an FHA loan, which then can be 30% higher than a conventional loan. You'll need a minimum credit score of 580.
A good provider for FHA and first-time homeowner loans, you'll also need a 580 or above to qualify for a PennyMac loan. The company is so confident it provides the lowest rates it will give you a $250 VISA card if you find lower rates.
What to do if you don’t pre-qualify for your dream home
Oftentimes people get so focused on securing their pre-qualification letter that they don’t think about what they’ll do if they don’t pre-qualify for the loan they want. If this happens to you, there are several options at your fingertips.
The first is simply to lower your budget and start looking at more affordable houses. Many banks aren’t supplying the jumbo loans they used to, and they’re also being more cautious about who they lend to and how much. Partially due to the 2008 housing crisis, and also partially due to the relatively high unemployment rates that happened during COVID, lenders are being much pickier about who gets approved for what these days.
All of that is to say, don’t be too hard on yourself if you don’t pre-qualify for the home of your dreams or a loan within your dream-home budget. If lowering your budget doesn’t feel like the right option for you, you might also consider spending some time to improve your finances before re-applying. This could include things like working to improve your credit score, pay off your debts to free up more income, or even starting a side hustle to earn more money.
The most important thing to remember is that pre-approval letters (like the mortgage itself) should always start and end with your budget. This is why I recommend coming up with a budget before seeing any houses. If you start visiting $500k houses but only can realistically afford a $300k house, you’ll just be setting yourself up for disappointment. Budget is often one of the first things real estate agents will ask about, for similar reasons: They want to show you the best houses available within your budget. Sit down with your family members to calculate just how much you’re able (and willing) to pay each month, then go from there.
What is the difference between pre-approval and pre-qualified?
Pre-qualified is an estimate of what you can borrow that gives you a good look at what you can afford while pre-approval takes it a step further and is closer to a lender's guarantee they will complete the mortgage process. You won't have to provide tax information to pre-qualify.
How long does a pre-approval letter last?
The offer letter is typically good for 90 days. After that, you will have to start the process again.
Which one do sellers prefer?
The pre-approval is closer to a finished mortgage offer and shows more commitment than pre-qualified. You'll get in the door but in this crazy market being armed with an approval letter over a qualification letter increases your odds of your offer being accepted.
The bottom line
Once you have your pre-qualification letter in hand, you’re ready to get started house hunting. Keep in mind that pre-approval letters are just the first step when it comes to getting your financial ducks in a row as a new homeowner. There are a lot of other components of homeownership you’ll want to plan for, including things like saving up for your down payment and setting aside some cash for closing costs.
You’ll also want to spend some time shopping around for the best mortgage options and completing loan applications with the lenders offering the most competitive interest rates. Buying a home for the first time can easily become a part-time job, so it’s important to take it step by step. Whenever you’re ready, start determining your budget and securing a pre-approval letter. Then check out our other first-time home buying guides for the next steps.