Mortgage concepts homebuyers should know

Home purchasers sometimes get into trouble because they don't truly know the sequence of steps involved in financing their purchase. The steps are qualification, pre-approval, approval, lock and appraisal.

Qualification (or pre-qualification, as it is often called). It is an opinion that your income, assets and current debts qualify you for a loan of some specified amount. The opinion may come from a lender or a real estate agent, or it may be your own, based on your use of an affordability calculator.

Whatever the source, the opinion does not take your credit into account, and no one is committed by it. It used to be that real estate agents did a lot of qualifications, often back-of-the-envelope affairs, so that they would not waste time looking for houses in a price range the buyer could not afford. Increasingly, they ask prospective buyers to become pre-approved by a lender because it is more reliable than a qualification.

Most lenders are willing to provide pre-approvals free of charge because the recipients might become borrowers. Home sellers have also learned to ask potential buyers for pre-approvals.

Pre-approval. This is a conditional commitment by a lender to make a loan prior to the identification of a specific property. On a pre-approval, unlike a qualification, the lender verifies the information you provide and checks your credit.

A pre-approval will stipulate a loan amount or monthly payment but not necessarily the loan type or the price. The lender's commitment under a pre-approval is always conditional, and rarely are the conditions spelled out.

Pre-approvals don't have expiration dates, but some considerable time may elapse before the borrower receiving a pre-approval comes back to convert it into an approval. During that time, things can happen that cause the lender to back off. For example, the borrower's credit deteriorates, or the person becomes unemployed. No one can reasonably expect a lender to approve a loan in those circumstances.

Less clear-cut are the impacts of adverse market changes, such as a tightening of underwriting requirements. If a lender has pre-approved a loan and the market changes to the point where the same loan would not now be approvable, will the lender honor its obligation? I fear that in most, if not all cases, the answer is no. Fortunately, abrupt changes in underwriting rules occur very infrequently.

I recommend that purchasers get pre-approved as a way of establishing their bona fides to home sellers and real estate agents. Only one pre-approval is needed, and it does not commit home shoppers to the issuing lender.

It is only fair, however, to include that lender among the loan providers you shop when you have a contract to purchase and need a loan. But bear in mind that if you switch to B after being pre-approved by A, you must now be approved by B.

Self-approval. Prospective home purchasers who want to know their prospects for loan approval before they begin a house search can use the loan approval calculator on my website (http://www.mtgprofessor.com). The calculator uses underwriting requirements posted by participating lenders, including credit-score requirements, but the user must enter her own credit score, which might differ a little from the score obtained by a lender.

Lender approval. This is a commitment by a lender to make a loan. Unlike a pre-approval, a specific property is identified and the loan details are spelled out. These include the type and purpose of the loan, the down payment, and the type of documentation. It will also include a minimum appraised value and an interest rate, even though a rate is not firmly established until it is locked.

The presumption underlying an approval is that the probability of closure is high - much higher than with a pre-approval. It is not 100 percent, however, because borrowers sometimes drop out, and sometimes one or more of the conditions that accompany the approval are not met. Approval letters contain "prior to doc" and "prior to funding" conditions, which are checklists of nitty-gritty details that must be completed before the final documents are drawn and funds are disbursed. Sometimes, these details derail the train.

Lock. This is a commitment by the lender to a specified price - rate and points. Ordinarily, a lender locks at the borrower's request and views the borrower as being committed, as well, though they don't always communicate this very well, or at all. Since locking imposes a cost on lenders, some charge a nonrefundable fee, which may be credited to the borrower at closing.

I recommend that when your loan is approved, you lock the price the same day because that is when you know the price. Holding off because you expect market interest rates to decline is a bad gamble. Besides, unless you can monitor your rate on the lender's website, the market rate when you finally lock will be what the lender says it is.

Appraisal. This is an opinion of how much a property is worth, based mainly on recent transactions of similar properties in the same market area, with allowance for differences between the properties.

While the quality of appraisals has deteriorated in recent years for reasons I have discussed in previous articles, they remain critical in any purchase transaction that requires a mortgage.

Mortgage lenders base the maximum amount they will lend on any property on the lower of purchase price or appraisal. This means that if the appraisal comes in below the price, either the seller must reduce the price to the appraised value, or the borrower must make a larger down payment.

Usually the seller gives way, but in a seller's market in which prices have been rising, the buyer may be forced to put up more cash.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. http://www.mtgprofessor.com.