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Do Home Buyers Need a Pre-Approval?

06/21/2014 05:24 pm ET | Updated Nov 11, 2014

With bargaining power shifting from home buyers to sellers in an increasing number of local markets, buyers in competition with other buyers are looking for any edge they can get. One possible edge is a pre-approval letter (henceforth PAL) from a lender.

Pre-Approval Defined: A PAL is a statement by a lender that a prospective buyer has the income, assets and credit to be approved for the mortgage required to purchase a house of some assumed value. To a prospective seller, the PAL is evidence that the prospective buyer can be taken seriously. It is not conclusive evidence, it is a lender's opinion rather than a commitment, and the opinions of some lenders are a lot better than the opinions of others.

The Best PALs Carry the Signature of an Underwriter: Because an underwriter's job is accepting and rejecting loan applicants, they should be the one responsible for issuing a PAL. But underwriters dealing with loan applicants work with a complete file, which includes an appraisal, whereas PALs are based on incomplete information and no appraisal. For this reason, many lenders are reluctant to use underwriters to generate PALs and leave the task for loan officers. PALs issued by loan officers have much less credibility than PALs issued by underwriters, though a house seller may or may not recognize the difference.

Realtors Like PALs: Realtors frequently recommend PALs to clients. PALs allow Realtors to avoid wasting their time on wannabe buyers who can't qualify for the loans needed to complete purchases.

Why Lenders Offer PALs: Lenders view PALs as a way to generate more business on the assumption that some of the buyers obtaining PALs will return for a loan. But the borrower is not committed to the lender providing the PAL, any more than the lender is committed to making a loan.

Weakness of All PALs: The major weakness of all PALs is that they are based on incomplete data that do not bind the lender issuing it. If the PAL shows an acceptable monthly mortgage payment, the interest rate used to calculate it is not guaranteed and won't be until the borrower submits a complete application and the rate is locked. If the PAL shows an acceptable maximum loan, the maximum will be contingent upon a property appraisal of some minimum amount. The PAL also uses income and asset data provided by the prospective buyer, which the lender won't bother verifying until the buyer submits an application.

The PAL is Particularly Weak in Connection With Self-Employed Borrowers: The tightening of underwriting requirements after the financial crisis had a disproportionate impact on self-employed borrowers who have to document their income from tax returns over 2 years. This can be a time-consuming chore which few lenders are willing to do for uncommitted shoppers. If I were a seller, I would not be impressed with a PAL for a self-employed buyer, and if I were a self-employed buyer, I would look for a better way to prove my bona fides to a seller than a PAL.

A Strategy More Credible Than a PAL: My son recently purchased a home in an active market, using a very different technique. He offered the seller a deposit equal to 5% of the price and removed all conditions from the transaction. He discarded the widely used mortgage contingency clause under which a transaction is voided if the buyer cannot obtain the mortgage required to complete the purchase. He also left out any requirement that he be able to sell his existing house. The seller thus knew that if for any reason my son could not complete the transaction, the deposit was the seller's to keep. The seller grabbed the offer.

Of course, this approach only works for buyers who are well-heeled. Some such buyers can document possession of liquid assets in excess of the sale price, which is also more persuasive than a PAL.

Bottom Line: Prospective home buyers who cannot purchase a house without a mortgage but do not have access to more powerful strategies for impressing sellers should get a PAL. Only one is needed, but take the trouble of finding one that is signed by the lender's underwriter.

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