Preapprovals prove less reliable

Self-employed borrowers learn lesson the hard way

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Self-employed borrowers learn lesson the hard way

Jack Guttentag
Inman News™

In a tight market, preapprovals are needed more than ever to establish the financial bona fides of home purchasers. Unfortunately, preapprovals have also become less reliable, especially for self-employed borrowers.

A preapproval 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. The statement is an opinion, not a commitment. Realtors frequently recommend that prospective purchasers get preapproved so that home sellers will take them seriously. Probably just as important to Realtors, they don't want to waste time on buyers who can't qualify for the loans needed to complete purchases.

A preapproval letter may be expressed in terms of a maximum monthly mortgage payment, a maximum loan amount, and/or a maximum ratio of loan to value. If a mortgage payment is shown, the interest rate used to calculate it may be shown, but the rate used is not guaranteed and won't be until the borrower submits a complete application and the rate is locked.

If a maximum loan is specified, it will be contingent upon an appraisal of some minimum amount. The preapproval will also be dependent upon verification of information provided by the borrower and underwriting approval of the transaction.

Borrowers need not shop for a preapproval, and they don't need more than one. Lenders offer them as a way of generating loan business, hoping that the purchaser will view the preapproval as the first step in obtaining a loan.

But the borrower is not committed to the lender providing the preapproval, anymore than the lender is committed to making a loan. Hence, when the time comes to convert the preapproval into an approval, other loan providers should be shopped as well.

A mortgage preapproval is stronger than a prequalification because preapproval includes an assessment of the borrower's credit, but prequalification does not. A preapproval is weaker than an approval, however, because the property value is preliminary and the mortgage rate is not known.

In addition, lenders may not take the same care in verifying the borrower's income or assets for a preapproval as they would for an approval. The case cited below is a good illustration of this.

As mortgage markets became increasingly restrictive after the financial crisis, more potential homebuyers were unable to qualify for the loans they needed. This increased the importance of preapprovals to home sellers, but it also reduced the reliability of preapprovals.

"We were preapproved for the loan we needed to purchase a house. After we found the house we wanted, we paid for an appraisal, inspection and title charges, and deposited earnest money. A week before the scheduled closing, they asked for our tax returns.

Just two days before the closing, they informed us that because the business income reported on our tax returns was 40 percent lower in 2009 than in 2008, they would not make the loan ... Can they do that legally?"

Lenders are never obligated to make a loan that does not meet their conditions, and preapprovals are so full of conditions and provisos that there is no way that they can be held to them. The problem is that the conditions have become much tougher than they had been, and especially so for self-employed borrowers, who now must run a gauntlet of rules and checks. That does not excuse the wretched business practice of the lender referred to in the quote, who waited until a week before the closing of a home purchase to examine the income of a self-employed borrower. That is inexcusable.

The bottom line for home sellers is that the reliability of preapprovals is not what they once were, especially for self-employed borrowers. The moral for self-employed borrowers with preapprovals is to avoid putting down earnest money until the preapproval has become an approval, which requires that the lender has reviewed and accepted all the documents.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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