What is the difference between a Prequalification vs a Preapproval letter and does it matter which one a potential buyer has?
Like many other good questions out there, there are many things to consider when deciding whether it matters if your potential buyer is prequalified or preapproved. The short answer is, it’s very important that your buyer has, at minimum, gone through one of these pre-loan application verification methods. A preapproval is a little more fool proof, but a quick prequalification can get you to a signed offer quicker. Neither method is a guarantee your buyer will get approved for their loan.
As the Seller, why should I care about how the buyer is getting their money?
16 years ago, on the very first piece of real estate I sold, I still remember thinking this exact question. There was a buyer financing section in the purchase agreement indicating how the buyer was going to pay for the transaction. I had no idea why that was even a part of the offer and why I would care either way. Over the course of several future transactions, and especially after getting into banking, I learned that it could be vitally important to the time, cost, and overall success of the transaction.
Time- Cash transactions don’t have to wait for, what can sometimes be lengthy, loan application approvals for their real estate transaction to close. Also, there can be a difference between loan types and the turn times it takes to get the loan approved. Government backed loans have a longer average approval length than a conventional mortgage. Another time factor to consider is how much time you can save with prospective buyers when you require a prequalification or preapproval letter from a lender before showing your property to a bunch of prospects who may not even be aware that they are not eligible for financing. You can use more of that time and energy on those that are qualified and prepared to make an offer.
Cost- If you are not careful on how your purchase agreement is structured and aware of what costs are paid by who, many times sellers can get stuck with more closing costs when a buyer obtains a mortgage rather than paying cash. There are ways to avoid this, but closing costs should always be in your thought process.
Overall Success- Maybe the very most important reason you should care about your buyer’s financing is that it can be the difference between a smooth transaction and one that goes sideways and dies an ugly death. It all comes down to mitigating exposure to risk. If a buyer is paying cash, it excludes a bunch of issues that can arise from more scrutiny that is involved with a lender. If a buyer is getting a government backed loan rather than a conventional loan, there is even more scrutiny that could be cause for financing to get denied. Some sellers take it even as far as considering which lending institution produced the letter. Is this lender known for being able to get loans approved, or is this a fly by night company that does a bad job vetting inquiries and hands out their letters like candy, just to crush a large percentage of them later when more details emerge?
So let’s get down to the differences of the two and what each of them are. Before we begin, I would be remiss if I did not quickly point out that in the industry, these two terms are many times interchanged and used incorrectly, almost as much as modular and manufactured housing, which is a whole other blog article we can cover in the future. The fact that they are often times interchanged should not dissuade you from making sure you understand which one your buyer has.
A prequalification is a letter from the lender that indicates that the lender has reviewed some, but maybe not all, of the information needed and that is currently available to make an approval or denial of the mortgage application. A prequalification can be extremely helpful for a potential buyer who has little time to put in an offer and needs a quick review from a lender. For a good and experienced loan officer, a prequalification letter can still be extremely accurate and should be able to give a seller a high level of confidence. A good lender must have thorough questions for a potential buyer if not reviewing all items generally required for a loan approval decision. What are some examples of information that may not be fully vetted in a prequalification?
Pay documentation- Sometimes a lender will be willing to accept a borrower's income verbally rather than wait for the paystub information.
Asset documentation- A lender can decide to forgo looking at asset statements and accept a verbal statement from the borrower who states they have enough in their account for down payment and other costs related to the transaction
Even if all documentation is obtained from a potential buyer, the loan officer may review these items for a prequalification, but they will still need to face further scrutiny by an underwriter once the home is under contract and the loan application is submitted.
The Good- Prequalification letters allow for the quickest answer as to whether or not there is a high likelihood of loan approval. An experienced lender can usually provide a prequalification letter in hours, allowing for a buyer to move quickly.
The Bad- They are not as thorough as a preapproval and puts more pressure on the loan officer to get it right.
Like the prequalification letter, a preapproval letter let’s the seller know a buyer has spoken to a lender who has vetted their information. A preapproval letter takes it a step further and many times will gather all currently available documentation such as paystubs, tax returns, bank statements, etc. and submits them for additional scrutiny and approval from an underwriter. While this process can take a bit more time and effort, it can eliminate many risk factors in a loan getting denied in the middle of the process.
The Good- Preapproval allows for the greatest reduction in risk associated with the buyer and their ability to obtain a loan. Generally, fewer snags are caught later in the process.
The Bad- True preapprovals can be time consuming and can hold up potential buyers from submitting an offer. Even after a borrower is preapproved, supporting documents that were used for their preapproval can expire, causing the need for updated documentation to be provided, which can be more aggravating and time consuming for a buyer.
Important Information to Consider When Evaluating a Preapproval or Prequalification Letter
Keep in mind, if you have a preference between the two types of letters, and are willing to only accept one type as a stipulation to entering an agreement with a potential buyer, understand that some lenders only provide one of the two options, and could limit which institution your buyer can work with. These letters are rarely, if ever, iron clad. Lenders design them in a way that allows them to deny a preapproved applicant for many reasons. As stated earlier, the lender only covers the information that was currently available at the time the inquiry was reviewed and any new or changing information can derail the financing. These letters are not tied to a certain property. The appraisal and title work provide other pieces needed for a full loan approval. Preapproval/Prequalification letters have telling information in the fine print, showing exactly what information was reviewed and vetted.
Who is the lender? Are they a well known local lender, or is it some online lender from across the country who knows nothing about your market and could derail the whole deal due to lack of quality service.
Is the buyer getting a Conventional or Government backed mortgage?
Stipulations- Always be aware of any additional stipulations that are added to the letter. “Seller must pay closing costs” or similar may be important to consider when receiving an offer.
When to Ask a Buyer for One of These Letters from a Lender
Most of the real estate industry has gone to asking for these letters prior to allowing a potential buyer to even look at a property. While this can be a great strategy for a realtor who wants to make sure they aren’t wasting their divided time on buyers who can’t purchase their property, individual home sellers are usually more willing to give their property as much exposure as possible. Maybe your prospect can’t get financing for the property, but maybe they can help generate more buzz in the community to draw attention to your real estate. It really is a personal preference though; some property owners want to only spend time on highly qualified and ready buyers.
There are still plenty of deals today that no letter is ever required, but less and less is this the case as sellers become more and more educated. Some real estate contracts require an approval letter within a certain number of days from the date of the agreement, but most transactions today require one before the contract is even signed.
Get Even More Information on the Subject
I wrote a shorter article recently related to this subject. Make sure to check out Home Sellers- What to Consider if Your Buyer is Getting a Loan. If all this preapproval/prequalification talk is giving you a migraine, The Selling Table is here for you. We can help take a lot of the stress off your shoulders when it comes time to sell your home, land, or commercial property. A For Sale by Owner transaction coordinator can help answer all those questions and get you going in the right direction.