If you're getting ready to buy a home, you might have heard that you need to be prequalified or preapproved before doing so. Even though both of these terms can guide you during your search for a new home, only one of them is practically essential for the home-buying process. Preapproval and prequalification are essentially two forms of mortgage approvals that indicate the steps lenders took to verify that you're able to afford a basic mortgage.

When you receive a prequalification or preapproval letter, you should be able to identify which homes you can afford while also displaying to the seller that you're serious about buying a home. This article offers a more detailed and in-depth guide on the difference between being preapproved and prequalified.

What Does Prequalified Mean?

The initial step you should take when you want to buy a home is to get prequalified. To do so, you will need to provide your bank or other type of lender with extensive financial information and documentation. The information that your lender will need to see includes your income, your total assets, and your current debt. Your lender will then review all of this information before providing you with an estimate of the amount of money you should be able to receive when applying for a mortgage loan.

Likely the best aspect of getting prequalified is that this process can occur online or over the phone. It's also important to note that the service is typically free. You should expect to receive your prequalification letter in around 1-3 days after you've applied. Keep in mind that becoming prequalified is considered to be easier than being preapproved because your lender won't look at your credit report or perform an in-depth analysis of your ability to buy a home.

If you have specific goals for your mortgage or monthly payment, you can discuss these while obtaining a prequalified letter. Your lender should explain the mortgage options at your disposal and help you gain a more informed understanding of what you can and cannot afford. Since your lender doesn't look at your credit report before issuing a prequalified letter, this type of letter doesn't carry as much weight as a preapproval letter.

What Does Preapproved Mean?

The next step in the process of buying a home is to be preapproved for a mortgage. Even though prequalification indicates that you have a certain level of creditworthiness and ability to borrow money, a preapproval is much more beneficial when you're trying to buy a home. First, you will need to fill out a mortgage application if you want to begin the preapproval process. You will then need to provide your lender with extensive documentation that allows them to perform a financial background and credit check. The documents that you might need to provide in order to begin the preapproval process include:

• At least two federal and state tax returns
• W-2 forms and a couple of recent pay stubs
• Statements of any real estate income you receive from a rental property
• 2-3 months of bank statements
• Two months of statements from any retirement and brokerage accounts you might have
• The most recent statement of real estate debt
• Rental payments for previous 12 months
• Bankruptcy and foreclosure documents if applicable

Once you progress through the preapproval process, you should have a better idea of what your interest rate will be as well as the amount of money you'll be able to spend on a single-family home. Keep in mind that the exact amount you can afford for a single-family home may differ from what you can afford when buying a condo or townhouse. Purchasing a condo or townhouse means that you'll likely be required to pay HOA fees, which will be included in your monthly mortgage payments.

Once you find out what your interest rate is likely going to be, your lender may provide you with the opportunity to lock in a specific interest rate. It's also possible that you will need to pay an application fee during the preapproval process, which could cost several hundred dollars. When you are set to receive a preapproval letter, your lender will give you a conditional commitment that states the specific loan amount you'll receive. If you're approved for a loan amount of $500,000, this means that you can start searching for a home at or below this price point.

Having a preapproval letter before you start searching for a home is highly recommended since it shows sellers that you're serious about buying a home. Even if you're approved for a high loan amount, it's important to understand that you don't need to purchase a home for the maximum loan amount you're able to receive. If you can find a less expensive home that meets your needs, you can set aside the extra cash you have for college funds, vacations, or retirement.

Determining How Much You Can Afford

If you're trying to find out how much you can afford before you even obtain a preapproval letter, there are several things you need to take into account. First, it's important that you determine how much income your household brings in every month. From here, you need to calculate all of your monthly debts, which include any student loan and car loan payments that you make.

The third and final thing that you should know before calculating how much you can afford is the amount of money that's currently in your savings account. Some or all of this money can be used to make your down payment. Your down payment is the amount of money you pay upfront for your home. If you pay $10,000 for a $200,000 home, this amounts to a down payment of 5%. Your lender will cover the rest. Keep in mind that the preferred down payment amount is anything above 20%, which will allow you to avoid purchasing private mortgage insurance. You should also receive a lower interest rate.

Even if your monthly debts and monthly income are mostly stable and consistent, unexpected expenses could reduce the amount of savings you have. You can take steps to mitigate this issue and protect your investment by making sure that you have three months of mortgage and debt payments in your savings account before going forward with buying a home. Even if an unexpected expense arises, you should still be able to pay your monthly mortgage bill. If you want to calculate how much you can afford when buying a home, there are plenty of useful calculators online that will give you this answer.

Do Preapproval and Prequalification Letters Affect Credit Score

First of all, the prequalification process occurs without the lender checking your credit score, which means that your credit score won't be impacted in a negative way. As for the preapproval process, any credit check that occurs is considered to be a soft inquiry, which won't change your credit score.

On the other hand, hard inquiries that result in a decreased score will occur when you apply for an auto loan or mortgage. Even though your score will drop, it should only last for 3-4 months. Keep in mind that all hard inquiries that take place in a 14-day period are treated as a single hard inquiry, which means that the impact to your credit score will be minimal.

Showing Sellers That You're Serious About Buying

Likely the main reason that you should seek a preapproval letter before you start searching for a home is because doing so shows the seller that you're serious about buying a home. In fact, many sellers will only show their property to potential buyers who have a preapproval letter.

Once you have the letter in hand, you and your real estate agent can start searching for homes without worrying about gaining some form of approval. Make sure that you keep the details of the letter in your mind at all times. If you're approved for $500,000, avoid looking at homes that cost $600,000 unless you're willing to stop your search until you've improved your financial situation.

Are These Mortgage Approvals Guaranteed?

If you obtain a prequalification letter or preapproval letter, you still can't be confident that you will receive a loan from the lender who provided you with this letter. First of all, a prequalification letter doesn't necessarily guarantee a preapproval letter. Even though you should be able to purchase a home once you have a preapproval letter, the closing process must still take place after your offer has been accepted.

The home that you've made an offer on must be inspected for possible repairs and appraised by a professional before the loan can be closed on. During this process, some issue could arise that makes it difficult for you to purchase a home. The home-buying process doesn't officially end until the title has been transferred from the previous owner to you.

When you're starting the home-buying process, one of the first things you should do is obtain a prequalified or preapproval letter. Once you've received a preapproval letter from your preferred lender, you can go forward with the home-buying process without worrying that you can't afford a home that you're interested in. You can be guided through this entire process with the assistance of a professional and reputable real estate agent.

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