What Is Pre approval?
Pre approval is a preliminary assessment by a lender that determines how much money an applicant is tentatively qualified to borrow for a loan, typically a mortgage. This process falls under the broader financial category of lending and personal finance. During pre approval, a financial institution evaluates an individual's financial information and credit history to provide a conditional commitment for a specific loan amount and estimated interest rate. A pre approval letter signals to sellers and real estate agents that the potential buyer is serious and likely to secure financing, streamlining the home-buying process.
History and Origin
While the concept of assessing a borrower's ability to repay dates back centuries, the formalization of "pre approval" as a distinct step in the lending process gained prominence with the evolution of modern mortgage markets. Prior to the mid-20th century, home loans were often short-term with large down payment requirements, making homeownership inaccessible to many. The establishment of federal agencies like the Federal Housing Administration (FHA) in 1934 and Fannie Mae in 1938 significantly transformed the mortgage landscape by introducing longer loan terms and lower down payments, which spurred greater demand for home financing. As mortgage lending became more complex and widespread, lenders developed more structured processes to assess borrower risk upfront. The systematic review of income, assets, and credit that defines pre approval emerged as a crucial step to provide both borrowers and sellers with greater certainty before committing to a property. This process helps ensure that a buyer's offer is credible and that they are financially capable of proceeding with the purchase.
Key Takeaways
- Pre approval is a conditional commitment from a lender, based on a thorough review of an applicant's financial standing.
- It provides a clear understanding of the maximum loan amount an individual may qualify for and an estimated interest rate.
- A pre approval letter strengthens a buyer's offer on a property, indicating their financial readiness to purchase.
- The process typically involves a "hard inquiry" on the applicant's credit report, which can have a minor, temporary impact on their credit score.
- Pre approval letters usually have an expiration date, often ranging from 60 to 90 days.
Interpreting the Pre approval
A pre approval letter is a statement from a lender that they are tentatively willing to lend money up to a certain amount.14 This letter is based on a review of the applicant's income, assets, debts, and credit record. It serves as a strong indicator of borrowing capacity, helping individuals understand their budget before seriously shopping for a home. While not a guaranteed loan offer, it suggests that the borrower meets the lender's initial requirements and is likely to receive final approval upon complete underwriting of the specific property. It's important to note that the pre approval amount reflects what the lender may be willing to lend, not necessarily what the borrower should spend.
Hypothetical Example
Sarah wants to buy a house and decides to get pre approved for a mortgage. She approaches a financial institution and submits her financial documents, including recent pay stubs, bank statements, and tax returns. The lender reviews her income, existing debts, and performs a hard pull on her credit report.
Based on her strong credit score of 780, stable employment, and a manageable debt-to-income ratio, the lender issues a pre approval letter for a mortgage up to $350,000 at an estimated interest rate of 6.5%. This pre approval is valid for 90 days. Armed with this information, Sarah now knows her approximate budget and can confidently start looking for homes within that price range, knowing that sellers will view her offer seriously.
Practical Applications
Pre approval is most commonly applied in real estate, particularly when securing a mortgage for a home purchase. It provides homebuyers with a clear understanding of their borrowing capacity, allowing them to focus their property search on homes within an affordable price range.13,12 For sellers, receiving an offer from a pre approved buyer offers confidence that the transaction is more likely to close successfully, as the buyer's financing has already been vetted.
Beyond mortgages, the concept of pre approval can also apply to other significant financial products, such as auto loans or large personal loans, though the rigor of the review process may vary. Regulatory bodies like the Consumer Financial Protection Bureau (CFPB) provide guidance to consumers on understanding pre approval letters and their implications, emphasizing that they are not a guaranteed loan offer.11 The Federal Reserve also issues supervisory policy and guidance topics related to real estate lending, highlighting the importance of sound risk management practices for financial institutions.10
Limitations and Criticisms
While beneficial, pre approval has limitations. A pre approval letter is not a guarantee of a loan and does not factor in the specific property being purchased. The final approval is contingent on a full underwriting process, which includes an appraisal and title search for the chosen property. If an applicant's financial situation changes significantly after receiving pre approval—such as taking on new debt, changing employment, or experiencing a drop in credit score—the lender may revoke or adjust the pre approval. Fur9thermore, some consumers might be tempted to borrow the maximum amount for which they are pre approved, potentially leading to overspending on a home that strains their long-term budget. It 8is essential for borrowers to maintain a stable financial profile from pre approval through to the final loan closing.
Pre approval vs. Prequalification
The terms pre approval and prequalification are often used interchangeably, but they represent different stages in the loan application process and carry different weights. Prequalification is a more informal, initial step where a lender provides an estimate of how much an individual might be able to borrow based on self-reported financial information. It usually does not involve a detailed verification of documents or a "hard pull" of the credit report, making it quicker and less impactful on the credit score.
In7 contrast, pre approval is a more formal and thorough process. It requires the applicant to submit financial documents, such as pay stubs, bank statements, and tax returns, which the lender then verifies. A hard inquiry on the credit report is typically part of pre approval., Co6nsequently, a pre approval letter carries more weight with sellers and real estate agents because it signifies a more robust assessment of the borrower's creditworthiness. While prequalification offers a general idea of affordability, pre approval is a conditional commitment, providing greater certainty regarding the loan amount.
FAQs
How long does a pre approval last?
Most pre approval letters are valid for 60 to 90 days. If you do not find a property and close on a loan within this period, you may need to reapply for pre approval, which could involve another credit check and updated financial documentation.
##5# Does pre approval guarantee a loan?
No, pre approval does not guarantee a loan. It is a conditional offer based on your financial information at the time of application. The final approval depends on a complete underwriting review of the specific property you intend to purchase, including an appraisal, and verification that your financial situation has not significantly changed.
##4# What documents are needed for pre approval?
To get pre approved, you'll typically need to provide proof of income (pay stubs, W-2s, tax returns), proof of assets (bank and investment statements), and information about your existing debts. The lender will also perform a credit check.
##3# Is it necessary to get pre approved before looking for a home?
While not strictly necessary, getting pre approved is highly recommended before seriously looking for a home. It helps you understand your budget, shows sellers that you are a serious buyer, and can expedite the offer process once you find a suitable property.
##2# Does pre approval affect your credit score?
Yes, pre approval typically involves a "hard inquiry" on your credit report. This can cause a slight, temporary drop in your credit score. However, multiple inquiries for a mortgage within a short period (usually 14-45 days) are often grouped as a single inquiry by credit scoring models, minimizing the impact.1