Homebuyers - You're Pre-Approved by Payment, not Purchase Price!

Lenders do a terrible job of educating homebuyers that they're actually approved for a monthly payment, not a purchase price.  Why don't pre-approval letters make this clear?  

July 26, 2009 -- Troy, MI -  A homebuyer follows instructions and jumps through the hoops (which are many today) necessary to get a pre-approval letter before looking at homes for sale.  They find one they like, at a price their pre-approval letter says they're good for, make an offer, negotiate back and forth with the seller and finally agree on a price.  They're elated. 

Then the rug gets pulled out from under them and they're told they don't qualify for this house and all their efforts were in vain. 

What's even scarier is that often the homebuyer doesn't find out they don't qualify for the property they got their hopes up for, until weeks into the formal approval process, sometimes only days before the target closing date. 

Why does this happen? 

The lender they were dealing with didn't do a very good job of explaining how the mortgage industry actually approves homebuyers.  Even if they did, it was just one of the numerous topics discussed and the homebuyer forgot about it.  Then, the lender didn't double-check the pre-approval requirements for the specific property. 

Because of issues like this, it's extremely important that homebuyers understand the following: 

MORTGAGE APPROVALS ARE MOSTLY BASED ON MONTHLY HOUSING PAYMENTS NOT PURCHASE PRICES! 

Let's study the pre-approval process to understand why. 

A homebuyer only makes so much money per month, which means they can only afford to spend a portion of that income on a monthly housing payment.  The rest of their income goes towards various income taxes, car payments, credit card payments, student loans, etc.  On top of that, unless the homebuyer wants to freeze in the dark during winter, they have to pay utilities to keep the heat & lights on (if you're outside the snowbelt, think air-conditioning). 

If you think about this, it makes sense.   

Now, let's look at an example homebuyer: 

Annual Income: $75,000                   

Monthly Debt Payments:  $1,000 

How much of a housing payment would this person qualify for? 

First, let's break the annual income down to a monthly basis:  $75,000 / 12 = $6,250/month income. 

FNMA/FHLMC typically allows 40% of one's gross monthly income to go towards monthly debt, including a housing payment.  The 40% number is called a Debt Ratio.  The other 60% of monthly income is allocated for income taxes, utilities, food, clothing, car insurance & gas and other necessities of life.  

So, to calculate the maximum amount of monthly debt allowed we calculate 40% of the monthly income: 

                                    $6,250 x 40% = $2,500. 

But, our example homebuyer already has $1,000 per month in existing debt.  That money then, cannot be allocated towards a housing payment.  So, we calculate what's left: 

                        $2500 minus current debt payments of $1,000 = $1,500 for a maximum housing payment 

This is what our example homebuyer could afford.  Now, they don't have to spend that much of course.  There are also other variables that could allow for a somewhat higher housing payment.  For example, if the homebuyer put 20% down, the 40% debt ratio might be allowed to increase to 45% as the higher down payment compensates for the higher debt ratio. 

Now that we know our example homebuyer's maximum housing payment we're done right?  Wrong - houses are sold by price, not monthly payments.  So now we have to convert the maximum housing payment to a purchase price. 

Here we run into a problem.  It's actually the reason many pre-approval letters are misleading and homebuyers get unpleasant surprises.   

The term "housing payment" is not the same thing as a mortgage payment.  The mortgage industry considers a housing payment to include the following:

            Mortgage payment

            Monthly amount for property taxes

            Monthly amount for home insurance

            Monthly association fees 

Property taxes are usually the biggest unknown when pre-approving a homebuyer for a home they haven't identified yet.  Depending on the state your in, property taxes can vary significantly for similarly priced homes.  Let's look at an example: 

                                                Assume:         

Loan amount:              $200,000

Interest Rate:              5.250%  (APR 5.891) no PMI

Home insurance:         $900 annually

If we compare these two monthly housing payments to our maximum payment allowed of $1,500, you can see that our example homebuyer would not qualify for property #2 - even though it had the exact same sales price as property #1. 

We'll leave the reason as to why property taxes may vary on similarly priced properties to a future article.  For now, just ask your local real estate expert. 

How can a homebuyer address this problem?  Simple, demand something in writing from the lender you get pre-approved by, that specifically states the maximum payment you're qualified for.  While they're at, they should also disclose the interest rate they pre-approved you at.  Interest rates change daily and if it takes you a month or two to find a property, higher rates could affect your pre-approval purchase price just like property taxes. 

Real estate agents also need to understand this issue to better assist their homebuyers.  Agents should contact their homebuyer's lender with the property taxes and any association fees to confirm the homebuyer does indeed qualify for the specific property, before writing an offer. 

Understanding the process, putting specifics in writing and relying on true professionals can remove many of the unpleasant surprises in the pre-approval and home buying process. 

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Drew Sygit writes and speaks about the mortgage & real estate industries.  He holds mortgage industry designations CMPS, CMC, CRMS, CMLO, CALO, has an MBA and is an approved industry instructor.  He's presented, spoken and/or written for HUD, Financial Planning Association, Financial Planners Association of Michigan, Michigan Association of CPA's, Institute of Continuing Legal Education, Oakland Real Estate Investors Association, North Oakland County Board of Realtors and numerous industry publications.  For speaking engagements and questions he can be reached at dsygit@TheLendingEdge.com.  He also publishes his own blog:  http://drewsmortgagenews.blogspot.com.