Pre-Approval: An Important Step in the Loan Process

There are several steps before you purchase a home or buy your next vehicle. One of the first steps in these processes is to be preapproved for a loan. While a pre-approval may seem unnecessary at first, the truth is that it’s a critical step in the loan process which can help make your end goal of buying a home or finding your next car easier.

1. What is a Pre-Approval?

A pre-approval is an evaluation by a lender of a potential borrower prior to approving a loan. Your credit score, financial history, and other factors will be looked at for this process. In other words, it’s an estimation of the risk of approving a borrower for a form of lending, whether it be for a mortgage, an auto loan, or a credit card.

Pre-approvals are an important step in the lending process for a variety of reasons. It’s proof to a lender that you’re serious about the loan you’re interested in. Your budget will also become clearer. You’ll be aware of how much you’re approved to borrow and at what terms, and from there can plan accordingly. Pre-approvals also make the lending process faster, ensuring everyone is on the same page and aware of where they stand with regards to the loan.

2. Pre-Approval for Mortgages

A mortgage pre-approval is one of the first steps you’ll take in the homebuying process. Like other pre-approvals, a mortgage pre-approval defines the interest rate and amount of money you’re approved to borrow. A variety of financial factors are assessed by the lender to see the mortgage terms you’ll be approved for.

Mortgage Pre-Approval—What's Needed?

For a mortgage pre-approval, the following items will be evaluated:

• Proof of Employment: This would include paystubs from the last month, as well as contact information from any employers within the last two years. Workplaces often have employment verification phone numbers which can be provided. If you're self-employed, you'll need to supply additional business documents.
  
  
• Tax Returns: You'll need to supply your tax return documents from the past two years. This includes your W2 forms.
  
  
• Bank Statements: The lender will need statements across your accounts from the last two months. This includes checking, savings, and money market accounts. You will also need to provide statements for any 401(k), IRA, or certificate accounts.
  
  
• Additional Income Sources: You'll need to report additional income sources if they apply, such as Social Security, bonuses, or child support.
  
  
• Loan Statements: The lender will need to look at statements from the previous two months for any loans you currently possess.
  
  
• A form of ID: You will also need to supply a form of ID, which could be a driver's license, Social Security card, or state ID.

The lender will also need to see your credit history. Specifically, they'll look at your report and score when considering your pre-approval. They will not do this without your authorization.

Is a Mortgage Pre-Approval Required?

While a mortgage pre-approval is not technically required to purchase a home, it’s to your advantage to complete one. A pre-approval is a signal to a mortgage lender, as well as a seller, that you are ready to buy a home. In a difficult homebuying market, this step can help relieve some of the stress that accompanies seeking out a home.

3. Other Types of Pre-Approvals

Outside of homes, what kind of other loans benefit from pre-approvals? Various auto and personal loans, as well as credit cards, may require them. Like other pre-approvals, these types tell a lender the story of your financial history and define the amount of money and interest rate that you’ll be approved for. These decisions are made to ensure you’ll be able to make your payments and continue to live within your means.

For these pre-approval processes, you’ll need many of the same documents that you would need to supply in a mortgage pre-approval. This includes a state-issued form of ID, pay stubs, tax returns, and bank statements. The type of loan you’re seeking, as well as your current stage in the loan process, may require additional documents. For instance, if you’re applying for an auto loan pre-approval and know the type of car you want to purchase, you’ll need to provide documentation on that vehicle.

4. Pre-Approval vs. Prequalification

You may often see the terms pre-approval and prequalification used interchangeably when it comes to loans. However, the two terms are very different. A prequalification is the process of seeing if you meet a lender’s requirements for a specific loan. A pre-approval, on the other hand, is the process of verifying your financial information and details to follow through on the loan.

Another major difference between a prequalification and a pre-approval applies to the credit check. A pre-approval often uses a hard credit pull, which may affect your credit score, while a prequalification is more likely to use a soft credit pull and not impact your credit score. If you’re hesitant to follow through on a mortgage or other loan, a prequalification may be the better option for your current financial situation.

Prequalification is initiated by the financial institution to present an offer with a range of terms based on incomplete data. Pre-approval is a response by a lender, initiated by an application, for a potential borrower to learn the specific terms they are qualified for based on their detailed data.

5. Credit Card Pre-Approvals

A pre-approval for a credit card works in a lot of the same ways as for mortgages and auto loans. However, credit cards will carry different requirements which you’ll need to meet to be approved. Common requirements include specific credit score, income, and your debt-to-income ratio, which is your monthly income relative to your monthly debt.

Remember to not be discouraged if you aren’t pre-approved for a credit card you’re interested in. There are plenty of credit card options out there, including student credit cards and secured secured credit-building cards cards, which are designed for you to build credit and improve your credit score.