The Shortcomings of Preapprovals

It’s common advice for buyers to obtain a mortgage preapproval letter from a lender before going out with a real estate agent to look at homes. The rationale is that preapproval puts in writing the loan amount a buyer is qualified to receive, all but guaranteeing the price range the buyer can afford. Agents can then be reassured they are not wasting time on a client whose financing is likely to fall through.

Well, that’s flawed thinking.

A preapproval letter is not a loan commitment, which most real estate professionals understand. But equally important is that preapproval does not identify potential issues or “red flags” that may prevent a loan from closing. At best, a preapproval letter indicates that the lender is interested in providing financing to your client. At worst, it provides a false sense of security; it’s analogous to a purchase offer that contains a “Hubbard clause,” a condition that a buyer’s purchase is dependent upon their ability to sell another property. How many people would consider that type of scenario advantageous?

Preapproval does not take into account potential changes to a buyer’s financial situation, which could affect their loan offer. While a buyer may think their budget can easily support a down payment and monthly mortgage bills, a lender’s guidelines may show otherwise. If certain income or assets are not stable and continuous, then they are not considered verifiable. And if they are not verifiable, the lender removes the income or assets from the loan application—which frequently results in a loan denial.

This doesn’t mean there’s no value in requesting that your buyers obtain preapproval letters from their lenders. But it’s necessary to be aware of the red flags that lurk in the financial landscape of many buyers and to offer guidance on how to correct them. They may surface in credit reports, income documents, or asset account statements. And when they surface, they can be lethal to a real estate deal. The most common red flags include but are not limited to:

Credit Reports

• Disputed accounts
• Collection or judgment accounts
• Deferred student loans
• Late payments on installment loans

Income

• Recent changes in employment or job responsibilities
• Self-employed for less than 2 years
• Tax returns have Schedule E losses
• Tax returns reflect alimony payments
• Inconsistent history of supplemental income
• Base pay fluctuates from one pay period to another
• Gaps in employment

Assets

• Large cash deposits
• Insufficient funds to cover closing costs
• Insufficient funds to cover post-closing reserves

You’re not responsible for knowing when these red flags surface, and you shouldn’t be expected to resolve them for your clients. But you need to communicate to your customer why they are problematic for his or her mortgage application, as well as corrective steps. A key ingredient of your action plan should be to recommend a loan officer to your buyer who is willing and able to provide a “red flag analysis.” This analysis is a detailed, comprehensive disclosure that quantifies a buyer’s creditworthiness and his or her maximum purchase power. It is based on the client’s credit report and verifiable income and assets. Like a preapproval, the analysis is not a loan commitment; its value rests in eliminating the shortcomings of a preapproval letter, creating a positive environment for everyone.

Source: Tim Malburg, president of Wilton, Conn.-based Capstone Mortgage Company