Forget Mortgage Prequalification: Heres a Better Option

Getting preapproved is a good sign from a lender. Photo: Johnny Magnusson.

Most of us will need to secure a mortgage in order to buy a new home. You might be advised to get "prequalified" for a mortgage before you start house hunting... but you know what? Forget mortgage prequalification; there's a better option: getting "preapproved."

Prequalification vs. preapprovalImagine that you found your dream home and are ready to make an offer on it. You know that it's well within your price range and that you have the means to buy it, but the sellers don't. They know very little about you, and if their home is so nice, they may be receiving multiple bids on it. Such a situation is why it's smart to talk to a lender before getting serious about a home. If you make your bid as a prequalified or preapproved buyer, that can give you an edge over other bidders, suggesting to the sellers that your offer won't fall through once the mortgage process gets under way in earnest.

But being prequalified or preapproved for a mortgage are two different things, with the latter carrying much more weight. Being prequalified for a mortgage involves having a chat with a lender and offering some information, such as how much you earn, how much debt you have, and what kind of credit rating you have. The lender then comes up with an estimate of how much you'll be able to borrow. You should then be able to get a document or letter from the lender that you can show sellers and their agents to let them see that you're prequalified to borrow a certain amount.

Getting preapproved for a mortgage is more involved. The lender will actually pull a copy of your credit score, instead of just relying on your word about your credit-worthiness. And you'll likely have to provide some financial documents and proof of your income over the past few years. Armed with that, the lender can assess your financial resources and evaluate your debt-to-income ratio, getting a sense of how much you can afford to spend on mortgage payments. Being preapproved means that a lender has made a commitment to you, agreeing to lend you a certain sum. It can make you a far more attractive bidder on a home, as the preapproval suggests less chance of the deal falling apart before the closing.

Note that the preapproval doesn't last indefinitely. It may hold for just a few months. So get it once you're seriously house-hunting, not when you're just daydreaming about a new home and visiting an open house every few weeks.

How much can you afford?Getting preapproved for a mortgage can help you compete better in a bidding war.

When getting prequalified or preapproved, there's a key mistake you don't want to make: You don't want to put too much stock in the maximum borrowing figure provided by your lender. Yes, it has meaning, and yes, it can help you snag a home. But it might also lead you to buy more house than you can afford. After all, the lender makes more money by lending you more money, and he doesn't know your entire financial situation, including the needs of your family, the security of your job, your life goals, and so on.

It's accordingly important for you to separately figure out how much home you can afford to buy. You can do so on your own, and you should. It's critically important, lest you end up buying a home with mortgage payments that leave you with little room for error. Remember that you need a cushion, in case of financial emergencies such as a job loss or big medical bills.

Don't rely on the conventional wisdom that you should spend no more than 25% to 30%of your gross monthly income on housing (including property taxes and insurance), as this isn't a one-size-fits-all matter. Instead, crunch your own numbers and figure out whatyoucan afford. Total your household expenses, such as food, utilities, transportation, insurance, travel, entertainment, auto maintenance, debt payments, contributions to savings accounts, and so on but not your rent. Subtract that total from your household income and you'll get a rough idea of what you might be able to spend on housing. Don't aim to spend all of that, though partly in case you need more money later and partly because buying a new home typically involves a lot of extra expense, such as repairs, renovations, furnishings, and perhaps a new refrigerator or a membership fee at a local club. If you're selling a home in order to buy the new one, you might need to spend there, too, to get it looking its best.

An added benefit of determining just how much house you can afford to buy is that it can make your home-shopping more efficient as you won't be wasting time looking at ones that are out of your price range. Armed with preapproval and a solid sense of what you can buy, you'll be able to zero in on a new home better.

Finally, understand that even though mortgage preapproval is a better option than prequalification, it doesn't guarantee that you'll actually get a mortgage from that lender. The final decision will come later, from the lender's underwriter, who will take an even closer look at your financial condition, as well as at the property you want to buy. Still, as you start shopping, opt for the preapproval, not the prequalification.

The article Forget Mortgage Prequalification: Heres a Better Option originally appeared on Fool.com.

Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.