Pre-Qualification

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One of the most useless and overworked items in the real estate industry today is the pre-qualification for a loan. Sellers want buyers to be "pre-qualified", and buyers are seeking "pre-qualification" to convince buyers they are serious.

The level of work done for a pre-qualification varies. In some rare instances, the loan officer doing the work not only runs the credit, but verifies the income as consisting of the proper income documentation paperwork (w-2s and/or taxes, plus pay stubs and/or testimonial letter) for the loan, and determines how much of a payment you can qualify for based upon known income and known indebtedness, and actually includes the assumed property tax due to purchase price in the payment calculations, and gives you an answer in how much you can qualify for based upon current rates at the time. This is a fair amount of work, consuming hours of time. A loan officer at a direct lender who goes through this whole procedure might be done in two or three hours. A loan officer working for a broker can actually take a full day, or even two, making calls to various lenders and shopping the loan around after the primary calculations are done. On real transactions, I've gone over two days on multiple occasions, trying to find a better loan.

The pitfalls and caveats are many. If the loan officer doesn't run your credit, which costs money, they really have no idea what your credit is like. If they don't verify your income, they are making a giant assumption that what you told them is accurate for purposes of a real estate loan (you get to use gross pay, but there are a multitude of potential adjustments). The payment you qualify for when you actually go to buy a house and get a real loan is a so-called PITI payment, which stands for principal, interest, taxes and insurance. Insurance is always an educated guess, unless and until you have a quote from a prospective insurer on a particular property for an adequate amount of coverage. Taxes here in California will be initially based upon sales price, and unless you live within one of the high property tax areas, is pretty much a set rate for the whole state, but there are many special assessment districts, scattered all over the state. I've seen properties with as many as four of these, although many if not most properties have none. It's much harder in some other states to even come up with a meaningful rule of thumb figure. All of these factors throw the taxes figure off.

Principal and interest - the actual loan payment - is what's left over from your allowed payment. From this, you can compute a principal loan amount based upon known interest rates.

Here's where the games really start. The first question is "What type of loan are they basing it on?" The thirty year fixed rate loan always has the highest rate, which means that if they assume a thirty year fixed rate loan, they are going to be able to "pre-qualify" you for less than somebody else can. What's the lowest rate, and hence the highest prequalification amount? A month-to-month variable or even a negative amortization loan. Somebody assuming they are going to qualify you for a negative amortization loan is going to "pre-qualify" you for the largest loan - more than you can really afford, as millions of people have discovered the hard way since I started writing this site. Which is more attractive to a client who doesn't know any better? That's right, the negative amortization loan. Which loan causes someone who is educated in mortgages want to drag the loan officer into the sunlight and stake them through the heart? That's right, the negative amortization loan. Amazing coincidence? Not really. From personal experience, many people do not want to become educated, even to the level of a competent layperson, and they will get taken for a ride as a consequence. What they want is to look at houses, pick out one they like, sign a couple sheets of paper, and move in. What these people are likely to get is a disaster. For several years, many people in my industry made a very high class living ripping off people like this while setting them up with a gotcha that was going to bite, and bite hard, but not until after they had their commissions and depart the scene. "How many houses are they going to buy from me, anyway?" is the typical thinking.

One more concern is the fact that while sub-prime loan rates are higher, and in most cases they will have a pre-payment penalty, where A paper loan rates are lower and in most cases do not have a pre-payment penalty. However, the highest payment A paper loans will allow is less than the highest payment sub-prime loans will allow, due to lower allowable debt to income ratio. So the loan officer can typically qualify you for a bigger loan based upon a sub-prime loan. See my article "Mortgage Markets and Providers."

Additionally, the rates on loans change every day. If the rates changes, so does the amount you qualify for with the same payment. It takes only a calculator to show that even an honest and complete "pre-qualification" done on a rate that's valid today may or may not be accurate by the time you actually find a home that you wish to purchase.

Another game loan officers play is with the rate versus cost and points tradeoff. It is counter-intuitive but true that it is actually easier to qualify someone for a lower rate. If you qualify for a given loan program at 5.5 percent, you will qualify for the same program at 5.25 percent, but you might not qualify at 5.75 percent. The reason is that the payment is (or should be) lower if the rate is lower, and payment is what qualification is based upon. The cost to you is that most people refinance or sell before they have recovered the additional costs of these lower rate loans. (See Mortgage Rate and Points for details and sample computations.) So they're going choose a loan that sticks you with multiple points - costs you're not likely to recover - all in the name of qualifying you for a larger dollar amount. The money to do that can make a difference on your loan to value ratio, as it eats up your planned down payment. So you want to be very careful that the loan officer's assumptions aren't planning to use the same money twice, because you can't spend the same dollar both on your down payment and buying your rate down.

THERE IS NO WIDELY-ACCEPTED STANDARD FOR "PRE-QUALIFICATION." Let me say that again. There is no widely accepted standard for prequalification. One more time: There is no widely accepted standard for prequalification. Consequently, everywhere in the nation, but particularly in California and other high cost areas, the pressures on providers to "pre-qualify" you for inflated numbers is intense. If you don't qualify for enough to buy any home, they obviously don't have a transaction. If they pre-qualify you for less than someone else, most people are more likely to go to that somewhere else, and the loan officer doesn't have a transaction. The competition is qualifying them based upon month-to-month variable loans or even negative amortization, and so if they don't as well, they don't have a transaction. Few loan officers qualify clients based upon how things really are, and the easy transactions where everything fits and the people qualify based upon traditional measures are mostly long gone. If the agent and loan officer doesn't have a transaction, they don't make any money. If they don't make any money, they don't stay in business, they can't make the payments on the Porsche, their house gets repossessed, their wife has to sell her jewelry to keep them off the streets, etcetera. It's not a pretty picture for them, and it often leads to them putting clients into situations they cannot really afford (I originally wrote that in June 2005, long before the mortgage meltdown became plain to everyone else). Finally, of course, the size of commissions is based upon the size of the transaction, so if they "pre-qualify" you for more, they have the prospect of making more when you buy the bigger house that you cannot really afford.

This doesn't even go into the issues of a stated income loan. Stated income loans are gone now, but when we had them were intended for self employed folks who get to deduct a large number of expenses everyone else doesn't. They were where a borrower couldn't prove income according to industry standards via taxes, w-2s, pay stubs, or perhaps bank statements for sub-prime loans, so they stated their income and in return for a higher interest rate, the bank agreed not to verify the actual income level. Please note that it's still got to make sense for someone in your profession. For example, if you are a school teacher they are not going to believe you $250,000 per year. But people do make up numbers much larger than the real amount they make. It is not for nothing that stated income was often called a "liar's loan". That is fine and good, as long as you actually can make the payment. When you can't it becomes a real issue. Not necessarily for the loan officer, who's going to get their money and depart the scene, and as long as you make the first payment or two they're off the hook. No. The one who's going to have to deal with the mess is you, the client. Keep in mind that as soon as the loan is funded, that loan officer is out of the picture whether you went through a direct lender or not, and they know it. That real estate agent is also out of the picture as soon as you have your house, and they know it. You've got to live with the situation they created, and they kind of know it, but often it just isn't important to them, and certainly not as important as seeing that they get paid, and paid as much as practical. So watch out, and shop around. The person who "pre-qualifies" you for the lowest amount may be the one you should do business with, because they are using assumptions you can actually live with. Go over their numbers with a calculator in hand.

The stated income loan leads into our next issue, which is that few people will expend the necessary effort to do a "pre-qualification" correctly. It takes several hours to do an accurate "pre-qualification" correctly, but a Wildly Assumptive Guess takes just a few minutes. You may imagine which is done more often, especially since the numbers will change with available rates anyway. This especially applies if the agent does not run credit or does not get income documentation. Due to the availability of the stated income loan when I first wrote this, there was no absolute need to obsess about accuracy and being sure of the numbers, and many loan officers still don't understand that this has changed. Due to pressures to come up with high numbers, loan officers still make assumptions that range from pretty optimistic to wildly optimistic. This is wonderful if you just want to be able to say you were a homeowner for a few months while the bank forecloses on you. It's not so great if you're trying to get into a survivable financial situation.

You may get the idea that when it comes right down to it, most "pre-qualifications" are convenient fiction, worth an approximately equal size of toilet paper, if not quite so soft on certain portions of your anatomy. You'd be correct. So "Why are they so ubiquitous?" becomes the obvious question.

The answer is sellers and seller's agents. Sellers are going to go through a significant amount of trouble and expense going through the motions of selling their homes. Furthermore, they can only have one proposed sale in process at a time and they may have a deadline. They understandably want some kind of reassurance that this buyer can actually qualify for the loan. For their part, seller's agents can be some of the laziest people I've ever met when you come right down to it. They've paid the money for the advertising that draws people or joining the big well-known National Brokerage With Television Advertising! Once they get the signature on a listing agreement, many think they're entitled to sit around with thumb you-know-where and wait for the commission to roll in. They don't want to go over the buyer's pre-qualification with the seller, and most of them have no idea as to how to do it. But they certainly don't want to carry out their part for more than one proposed transaction, hence their desire for this Magical thing called the "pre-qualification."

The correct way to respond to this concern, for a seller, is simple and yet many people think it's hard-nosed. Require a deposit. Require it be remitted to you on the last day of escrow as part of the initial contract, whether or not the loan funds. Now the standard form in California, as a default, makes the sale conditional upon the loan for seventeen days, but this can be changed by specific negotiation. True, you might scare away some buyers who aren't certain that they're qualified, and in buyer's markets this may scare them away entirely. But you won't enter into escrow with anyone who's unsure. You shouldn't rely on a "pre-qualification", which is basically just a piece of paper that's now been filled up with meaningless markings and so can't be used again for something more important, like a game of tic-tac-toe.

Furthermore, many buyer's agents, knowing how useless a "pre-qualification" is, don't want to take the time to do them themselves and so tell their clients to go get one somewhere else, but that when the time comes they have someone who will do the actual loan. It didn't take very long for the word on this practice to get out, and so loan officers and agents with a very short time in the business learn not to do them unless they are going to get something out of it. Which basically means control of the transaction or an upfront payment. I certainly can't name anybody with more than a few months in the business who will do a "pre-qualification" unless a client either signs a Buyer's Agent Agreement or pays them a fee or does something that assures them they will get a transaction. And if your agent says go get a "pre-qualification" on your own, go and get another agent. If they or the loan agent they recommend can't be bothered, then obviously they are too busy to give you the necessary attention to get your transaction done properly and on time. It's very hard to fight the system that requires a "pre-qualification," no matter how useless it is, but it's part of the work they signed on for. They should do it themselves. If they try to get someone else do do their work, consider it a Red Flag not to do business with them, because they're already trying to skate by without doing work that they should be doing. Being a good agent or loan officer is work, and that's what we get paid for. Somebody who's trying to do less work now is likely to try and skate by without doing important work later.

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About this Entry

This page contains a single entry by Dan Melson published on July 24, 2014 7:00 AM.

Time in Line of Work for Mortgage Qualification - What Counts? was the previous entry in this blog.

Loans On Related Party Transfers of Real Estate - Family, Corporate, or Partners is the next entry in this blog.

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