Pre-Qualification versus Pre-Approval
When you initially set out to purchase a property, the real estate agent(s) and home seller will want to know you can actually afford to purchase the property. After all, if you can’t afford to buy it, you’ll be wasting everyone’s time. Aside from affordability concerns, you may find other issues that disqualify you from obtaining a mortgage. For these reasons, most real estate agents will require that you get pre-approved, at a minimum, before they even begin showing you prospective properties. Most agents have a mortgage contact they’ll likely refer to you to get the ball rolling. Once you are under contract you should shop around to find the best mortgage product that meets your needs.
What Is a Pre-Qualification?
If you choose to finance the home purchase with a mortgage, you’ll need to get pre-qualified first. A “pre-qualification” isn’t as robust as a pre-approval, but it’s a good first step to ensure you can purchase the home you desire. A pre-qualification is a pretty straightforward, simple check to see what you can afford based on your income/debt level, assets, down payment, employment history, perceived credit score, and so on. You can get pre-qualified very quickly and easily with a bank or mortgage broker.
A pre-qualification is simply supplying estimates without any verification of the information you provided and without a look at your credit score. That said, a pre-qualification, or pre-qual, is just a determination of what you’d likely qualify for if you made an offer and applied for a home loan. Most contracts will require that you get a loan approval within a designated time frame before the contract can be considered binding.
What Is a Pre-Approval?
A pre-approval, on the other hand, actually has legs. It’s a written, conditional commitment from a bank or mortgage lender that says you are pre-approved for the mortgage financing in question. It comes only after filling out a loan application, supplying verified income, asset, and employment documentation( if not retired), running credit, and underwriting the loan file. Acquiring a pre-approval shows the interested parties (sellers, agents) that you’re a committed buyer, increasing your chances of sealing the deal at the price you want. It will also show you how much house you can afford, not just an estimate. You need to be prepared to produce bank statements, pay stubs, tax returns and authorization to run a credit check as part of the pre-approval process. Once you provide all the required documentation and get the pre-approval letter from a bank or lender, it is typically valid for 60-90 days. Just note that things can change during that time, such as your credit score, so it’s not 100% guaranteed.
One of the key factors in either a pre-qualification or pre-approval is your “debit to income” ratio.
The “debt-to-income ratio“, or “DTI ratio” as it’s known in the industry, is the way a bank or lender determines what you can afford in the way of a mortgage payment. By dividing all of your monthly liabilities by your gross monthly income, they come up with a percentage. This figure is known as your DTI, and must fall under a certain percent in order to qualify for a mortgage.
The maximum debt-to-income ratio will vary by mortgage lender, loan program, and investor, but the number generally ranges between 40-50%.
A basic example of debt-to-income ratio:
$120,000 annual gross income as reported on your tax returns/pay stubs
Monthly liabilities: $3,500
Monthly income: $10,000
35% debt-to-income ratio
In this example, your debt-to-income ratio would be 35%. However, the debt-to-income ratio goes into greater detail and comes up with two separate percentages, one for all of your monthly liabilities versus income (back-end DTI ratio), and one for just your monthly housing payment (including taxes and insurance) versus income (front-end DTI ratio).
Front-End and Back-End Debt-to-Income Ratios
So in the above example, if your monthly housing payment makes up $2,000 of your $3,500 in monthly liabilities, your front-end DTI ratio would be 20%, and your back-end DTI ratio would be 35%. Many banks and lenders require both numbers to fall under a certain percentage, though the back-end DTI ratio is more important.You may see a debt-to-income requirement of say 30/45. Using the example from above, your front-end DTI ratio of 20% would be 10% below the 30% limit, and your back-end DTI ratio of 35% would also have 10% clearance, allowing you to qualify for the loan program, at least as far as income is concerned.
Max DTI Ratio for FHA and VA Loans
The max DTI for FHA loans that are manually underwritten is 31/43. However, for borrowers who qualify under the FHA’s Energy Efficient Homes (EEH), “stretch ratios” of 33/45 are used. These limits can be even higher if the borrower has compensating factors, such as a large down payment, accumulated savings, solid credit history, potential for increased earnings, and so on.
For VA loans, the maximum debt-to-income ratio is 41% (back-end). Again, as with FHA loans, if you have compensating factors and the lender allows it, you can exceed the 41% threshold.
How to Figure Out Your DTI Ratio
If you’d like to figure out your debt-to-income ratio, simply take your average gross annual income based on your last two tax returns and divide it by 12. Then add up all your monthly liabilities and divide that total by your monthly income and voila. Keep in mind that you’ll need a free credit report to accurately see what all your monthly payments are.
The credit report will show you what your minimum or monthly payment is for each trade line, which makes it simple to add them up. Some banks and lenders allow installment credit cards such as those issued by American Express to be excluded from the debt-to-income ratio as they often account for thousands of dollars a month, and likely get paid off in full monthly.
The debt-to-income ratio is a great way to find out how much house you can afford, as well as the maximum mortgage payment you qualify for. Simply add up all your liabilities and your proposed mortgage payment plus taxes and insurance to see what type of loan you can take out.