What is mortgage prequalification?
The very first steps of the homebuying process can also be the most confusing. Where do you start? How do you know your purchasing power? Can you even afford to take out a mortgage? If you're wondering what's next, it might be a good time to seek mortgage prequalification.
By reviewing basic information about your financial background and employment history, lenders are able to gauge whether your situation is suitable for a mortgage.
Prequalification establishes how large of a loan you’ll be able to borrow if you decide to move forward with the mortgage process. While it does not guarantee a loan will be approved, prequalification does act as a great starting place to establish financial needs and outline how much money can be borrowed.
During prequalification, the borrower will provide documentation that lays out their financial status. This information is submitted by the prospective borrower and is not verified by the lender until a later stage. This gives the lender an overview of the borrower’s finances and helps determine if a mortgage loan is possible.
Let’s take a closer look at specific aspects that will be reviewed to determine if you prequalify for a mortgage loan.
When to get prequalified
In order to get the house hunting process underway, you’ll first need to know what you can and can’t afford. Some buyers will have their heart set on a property, only to find out later that they won’t qualify for enough financing to cover the cost. That’s why it’s always best to begin your real estate journey by getting prequalified.
By meeting with a lender and determining your borrowing limits early, you’ll be able to know exactly how much house you can afford and narrow down the property that suits your needs.
Mortgage prequalification documents to prepare
The prequalification process is relatively quick compared to other aspects of applying for a mortgage. By taking a high-level look at your fiscal background, lenders can generally determine how much you’ll be able to borrow, or whether you can afford a mortgage at all.
Here are some of the key aspects your lender will review when deciding your prequalification status:
- Employment history
- Credit score
- Debt to income ratio
To make sure you’re capable of repaying the loan, lenders will take a close look at your recent employment history. In addition to handing over pay stubs and proof of salary, your lender might contact your place of business to confirm you’ve had several years of stable employment. Typically, two years of gainful employment is sufficient for prequalification. If you’ve changed jobs recently, your previous employers may be contacted as well.
If you’re a self-employed borrower, you’ll need to submit paperwork that outlines the stability of your business, income levels, the products and services you offer and additional documentation.
Your credit score is a three-digit number that indicates the state of your finances and how you’ve managed debt in the past. By providing a snapshot of your current debts and settled loans, lenders can determine if you’re a promising candidate for financing.
A score of 670 or higher is considered “good” by most lenders. With a score in this range, you’ll have a much better chance of being prequalified and eventually approved for a mortgage.
One of the key aspects lenders will look at during prequalification is the borrower’s debt-to-income ratio, which assesses whether the borrower’s income is enough to cover monthly mortgage payments.
Debt-to-income ratio is a variable used by lenders to determine if a borrower’s financial situation can afford the added expense of a mortgage loan. It is calculated by taking the tota amount of the borrower’s monthly debt payments, divided by their gross monthly income.
Other debt obligations, such as student loans or car payments, will limit how much a borrower can afford for a mortgage loan. An ideal debt-to-income ratio can vary from lender to lender, but equal to or less than 35% is usually considered an acceptable threshold. Less than 20% is considered excellent, while a debt-to-income ratio of greater than 45% is typically the maximum percentage for prequalification.
Prequalification vs. Preapproval
Following prequalification, preapproval is another initial step in building a mortgage loan.
Prequalification indicates that a borrow may be approved for a loan, but it does not give a definitive answer as to whether the loan will be approved. Preapproval, on the other hand, takes a much more in-depth look at an individual’s finances and helps lenders determine how much loan the borrower can handle.
While the borrower’s credit score, employment history and current debts are all provided to the lender during prequalification, these submissions are not verified by the lender until preapproval.
It’s best to seek prequalification and preapproval before you begin shopping for a home. Some first-time homebuyers pick out their next home before meeting with a lender. This oversight often leads to unexpected issues, such as a limited borrowing capacity, that can cause the sale to fall through.
By seeking preapproval before landing on a home, borrowers can uncover, resolve or avoid these adverse issues before the mortgage process moves forward. With the knowledge of how much you’ll be able to borrow, you can explore buying options with the certainty that the property is in your price range.
When prospective homebuyers take the first step to buying a home, prequalification provides an excellent place to start.
By analyzing a borrower’s current financial situation and calculating their debt-to-income ratio, prequalification helps set manageable loan expectations and gives buyers the information they need to start shopping for a new home.
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