The Difference Between a Reliable and Unreliable Prequalification or Preapproval Letter

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If you don't know, chances are your agent doesn't either. Even if you know, chances are that your agent is as clueless as a newborn about loans.

I and my clients get asked for all kinds of nonsense (to put it very kindly). Every single one of them has some kind of idea what makes a good lender letter, and none of them are correct. As of this moment, not one single agent (other than me) has asked for anything in the way of a lender letter that means a damned thing.

The first thing to get into your head is that there is no such thing as a letter that guarantees funding on a loan pre-purchase contract. No loan officer can write a letter that guarantees a loan will fund. The only guarantee of funding is a loan commitment written by an underwriter, which may or may not have conditions a particular borrower can meet. They are always written to a specific property, and require (among many other things) either already holding title to the property or a fully negotiated purchase contract to buy a specific property. You tell me how any buyer is going to get that before the purchase contract is negotiated. Go on, we're waiting.

The fact is that loan officers cannot be held responsible for preapproval and prequalification letters. Unforseeable things really do pop up, loan standards change (I got lucky and didn't lose anyone when Freddie and Fannie changed their standards on investment property in late January 2009 - but that was sheer luck. Skill had nothing to do with it. I can name loan officers that lost sixty percent of their loans in progress through no fault of their own), a full underwrite of the file finds that the borrower applicant has somehow misrepresented their situation. Upshot: there is no such thing as an infallible lender letter. Nor can you sue the loan officer who wrote the letter. Since you can't sue the loan officer, many loan officers get very lazy about writing their lender letters. There is no magic bullet for determining who is and who isn't doing full due diligence. The loan officer writing a preapproval or prequalification has got to show his work, and you (or someone you trust) has got to have enough understanding of loans to follow that work and enough understanding of current loan standards to know whether such a loan can be done. There are no shortcuts to this that work, for all of the illegal, unethical, and just plain wishful thinking for one that get tried.

Let's list a couple of the wrong methods. The first and most common is dictating that you have to have a lender letter from a particular lender or loan officer. This is illegal under RESPA. I don't care how many years you've been doing it, or how many times you've done it, it's still illegal. it doesn't matter if the client is dictating the choice of lender, it is still illegal under RESPA. I don't care who the specific lender or loan officer is, it is still illegal under RESPA. Everybody involved is breaking the law - whomever designates the specific provider, you for going along with it, and any lender involved if they are aware of it. I offer the client the option of whether they want to go get the lender letter from the specified source anyway as a way of not making waves in the transaction, but this is common enough that I've gone to the trouble of making up a template for letters to send to Department of Housing and Urban Development later. The folks at HUD are well aware that agents and Realtors do this for kickback and mutual referral purposes, and they frown on it severely. You can win the argument for the transaction if you're silly enough to insist, but six months down the line HUD is going to be knocking at your doorstep for a RESPA violation, and it's probably not a good idea to be telling them how long you've been doing it wrong and how. An agent might keep their license over one although they're going to be facing hefty fines, and I'm sure that as a client you'd rush right out and sign up with an agent who has broken the law, right? Better for all concerned not to do it at all. If you're an agent who does this now, stop immediately. All it takes is one complaint, and HUD will often subpoena back records of all of your former listings. Ignorance is no excuse.

Of late, the "must have letter from direct lender" has gotten more popular, although this is another way of simply ruining a piece of paper. No big loss, but it doesn't mean anything more from a direct lender than it does from a broker. Less, actually, as most loan officers working for direct lenders are a lot less experienced in the ways that loans get rejected. Nor are they any better at taking into account the effects of a specific transaction upon likelihood to qualify. They aren't any better at knowledge of lending standards, either. I've seen some pretty stupid letters from direct lenders that brokers with a broader knowledge of industry standards would laugh at. This requirement is useless if not counterproductive, and is usually practiced by agents looking for a cheap way to cover their backside in case the transaction falls apart, in which case they will show the client "See, they had a letter from National Megabank! If we can't trust them, who can we trust?" This entire line of thinking is what logicians call a Red Herring - an irrelevant distraction to the important question, and even counterproductive in this particular case, and if you have a competent real estate agent, they should know enough to know better.

Enough of what a good lender letter isn't. Let's talk about what it is.

First of all, a lender's letter must be specific to a given purchase offer. It has to be written in accordance with the purchase offer that is being made, and therefore written within no more than one business day prior to the tender of the offer. "Why" You ask? Because every single transaction is different. Rates change every day - or more specifically, the tradeoff between rate and cost changes every day. The purchase price being offered on this transaction is not the same as the purchase price they may have offered last time, and the down payment may not be the same, meaning the loan amount and the projected payment are not the same, either. The borrower may no longer have sufficient cash to consummate the transaction with all of these changes. All of this is basic, "hit the ball with the bat" level stuff. If any of it changes, so can the answer to the question of whether a loan is possible. There are still people wandering around with lenders letters that are months old; with the standards changes of the last three months the only things those are useful for is tinder for a fire or a good laugh.

Second, and even more importantly, the loan officer must show their work. What's the borrower's known and documented income? What are their cash reserves available for this loan? You want a lender's letter that testifies to the exact amount of cash reserves the borrower has shown, details where any additional funding is coming from, and how long of a period how much income is averaged over (at least 17 months), to give a figure for monthly income. It should also specify the actual FICO score reported by each major agency. You can't hold the loan officer who wrote the letter responsible if the loan fails to fund, but you can hold them responsible for specific statements about assets and income and credit score. Not only that, having this information gives you the opportunity to check their work! Indeed, the only advantage of not showing such information is that it gives weak or unqualified buyer/borrowers a chance to pull the wool over someone's eyes, and since those buyers are risking thousands of dollars that is clearly not to their benefit either. These numbers are what is really important, not the identity of someone who writes a "black box" letter - "I don't know how they're qualified, but this says they are!" Wouldn't you really rather be able to check and know?

A good lender's letter will lead you through the calculations of loan to value ratio and the specific rate, point, and closing costs of the loan being contemplated, as well as required reserves for prepaid interest and impound account and compare it to known assets to determine that the buyer really does have enough cash to close the transaction. If they don't and you accept their offer, you are praying for a miracle because that is what it will take to make this loan close.

A good lender's letter will also go through the computations for debt to income ratio based upon the loan quoted. They have determined income averaged over a period which leads to average monthly income. You should be able to determine within a very close range exactly what the other costs of owning the property are going to be. The lender's letter should state a number for monthly debt service for existing obligations - credit cards, student loans, car payments, etcetera. This number is available right on the credit report, and if the credit report is not used as the source of this number, there should be a good explanation as to why the number on the credit report was not used. You don't need to know the social security number and all of the account numbers, or even all of the individual payments. What you do need to know - what you are entitled to know - is whether they qualify for the loan, which means the total of existing monthly debt service is necessary. It is also sufficient unto the task, which means you have no justification for asking for more information. If the total cost of owning the property and existing debt service fit within appropriate debt to income ratio guidelines, you have a qualified buyer. If not, you are wasting your time accepting their offer because they are not going to qualify. Stated income loans are all but dead, and the rates for the few remaining providers are not anywhere close to normal rate/cost tradeoff - you can figure at least a two percent differential right now at the same cost as well as a rock bottom equity requirement of twenty percent - more likely twenty-five to thirty. Your buyer is going to have to document income to the lender in order to qualify for that loan, so they can bloody well tell the seller how much income they can document. That seller is making a decision of whether to grant credit, and if the buyers cannot qualify for that loan probably going to cost those sellers thousands of dollars. Therefore, the seller is completely justified in asking for this information - they are perfectly justified in requiring it.

The contemplated loan should have been priced within one business day of submitting that offer to purchase, and it needs to include both a rate and a total cost of that loan that you can check. Yes, the available tradeoffs between rate and cost vary every day, but the longer you go between pricing and submission, the more opportunity there is for change. I'm a lot more comfortable with lender's letters where the quoted loans priced with low to no points (if not a zero cost loan). Why? Simply because there is wiggle room on the quote. If rates go up a quarter of a point for the same rate tomorrow, or a week from now, the buyer can quite likely still make it work - particularly if they're not pledged right up to the limit of their available assets. Similarly, I like to see a lender letter that's built some wiggle room into the cash to close. It's the difference between a very qualified buyer who can still make the transaction happen if rates go up a bit or costs are slightly higher, and a marginally qualified buyer who is going to crash and burn if any little obstacle comes up (If the buyer was lowballed on their mortgage quote to use one all but universal example), or at least need the seller to bail them out with further concessions. If the loan officer who wrote the lender letter shows the work, it helps you know the difference between these two very different buyers, as well as between them and the completely unqualified bozo. It can be worth the risk of dealing with the marginally qualified buyer if you are getting a particularly good price and have the money to lose if the transaction falls apart, but it shouldn't be any surprise that the solidly qualified buyer is in a stronger bargaining position and likely to get a better price, thereby giving that solidly qualified buyer a reason to want to show all of this, demonstrating what a strong qualified buyer they are and what a strong offer they are making. Depending upon the seller's financial position, in San Diego this can be worth ten thousand dollars or more on the sales price of an average home!

I have shown that both the buyer and the seller are better off with a solid lender's letter that takes the cash and the income necessary to fund that loan and compares them in concrete numerical terms with the buyer's financial resources and liabilities. These aren't the only questions possible, and therefore the need for loan officer contact information. I call the loan officer on every single lender letter I get and ask questions - does this buyer own investment property being particularly important right now. If they're claiming something I don't believe can be done, I'm going to ask what lender is willing to fund that loan and then check if such a program exists to actually do so - and either I learn something new about the current loan market or I prevent my seller client from accepting an offer that cannot be consummated.

The important thing is concrete information being attested to, that allows any other person who knows enough about loans to retrace the work and verify whether a loan can be done under current conditions. If the agent can do it, great - agents should know enough about loans to do so! Even if they don't, any loan officer should be able to do the work. The identity of who wrote the letter is trivial - a distraction dreamed up by agents who are incompetent to judge, looking for kickbacks, or both. I will take a letter with the required information from any loan officer that I don't know to be a complete and utter bozo, and even then, I have the information they are using to make that determination, which is one hell of a lot stronger than reputation or lack thereof. The critical information is specific concrete numbers about the buyer's situation that enable anyone who knows loans to make an informed decision as to whether this loan is doable, not whose signature is on it, or which letterhead it's printed on. When I make a recommendation to accept an offer or even just pass it along without a recommendation against, I am telling my seller that I have a reasonable basis to believe that this potential buyer has the wherewithal to make it happen. If I'm not doing the necessary due diligence before I do that, I have failed in my fiduciary duty - and that means knowing the difference between what is important and what is not. Having all the numbers for me or another loan officer to trace and check the work is important. The identity of who wrote the letter is not.

Caveat Emptor.

P.S. If you're looking for an example of a good lender letter, you could do worse than The Qualification Letter I Use

Article UPDATED here

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This page contains a single entry by Dan Melson published on March 11, 2009 7:00 AM.

Zero Cost Real Estate Loans was the previous entry in this blog.

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