“Do you have a pre-approval?” is often one of the first questions real estate agents ask when you begin negotiating the purchase of a property. Pre-approvals indicate to agents and vendors that you’re a genuine buyer. They can also give you confidence to make offers because you know exactly what your budget is.
But rising interest rates could mean your pre-approval isn’t worth the paper it’s printed on. Get it wrong and you could be left short when it comes time to finalise your home loan and the purchase of your property. Get it really wrong and you could even find that the 10% deposit you’ve paid to the vendor is at risk.
What is a pre-approval?
A pre-approval is when your lender gives you ‘conditional’ approval to borrow money to buy a home before you’ve found the home you want to buy. Pre-approvals are common practice in Australia.
There is nothing final or binding about a pre-approval. At the end of the day, the lender could still decide not to lend you the money. For example, if they don’t like the property you’re buying or if your income position has changed since you applied. Another reason they might decline final approval is because interest rates have gone up (more on this key point in a moment!).
So why bother with a pre-approval if they’re not binding? Because done right, they can provide you with a level of confidence about how much you can borrow and thus how much you can spend. The key to getting it right is to submit an accurate application in the first place, which your mortgage broker is trained to do.
Why all pre-approvals aren’t created equal
Another key to success is knowing what sort of pre-approval you’ve got. Some pre-approvals are assessed by the lender’s credit team. This means they are pretty much good to go provided the property you find is satisfactory to the bank (and your financial position hasn’t changed).
On the other hand, some lenders issue computer-generated pre-approvals. They are literally spat out within two minutes of your application being submitted. That means they’re only as good as the person who put the application together.
What’s the risk in a rising interest rate environment?
Pre-approvals carry extra risk in a rising interest rate environment. Let’s explore why.
To determine whether you can afford a loan, lenders typically assess you using the rate of the day plus a buffer of about 3%. So if the rate is 2.5%, they will assess you at 5.5%. This tells them that you can afford the loan at today’s rates and if they increase. It’s a safety net for you and for them.
But what happens if rates go up whilst you’re looking for a property? The answer depends on which lender you’ve chosen. With some lenders – even if you have a pre-approval – they will reassess you when you find the property you want to buy.
If rates have gone up, and you’re borrowing right up to your maximum, you may not have enough wriggle room to accommodate the higher rate. That could mean a lower loan.
At this point you have two options – find more money or walk away from the purchase. In a disastrous scenario, it may mean loosing your 10% deposit if you waived your cooling off rights and the vendor is unsympathetic to your plight.
Some lenders, on the other hand, will ‘honour’ the assessment they did at the pre-approval stage. Provided you buy within the 90 day pre-approval window and don’t seek to increase your loan amount, then you won’t be reassessed at the higher rate and you’ll still be able to borrow the amount you were pre-approved for.
Confused? Let’s look at an example.
Sarah and Tom are granted pre-approval for a loan of $500,000 with Lender A. At the time, the interest rate for their chosen product is 3.5%. Two months later they exchange contracts on a property and submit to Lender A for unconditional approval. However, in that time, the rate on their product has gone up to 4.5%.
When they submit their unconditional request, the lender reassesses them at the higher rate and finds that Sarah and Tom can now only borrow $450,000.
At this stage, Sarah and Tom have two options – find $50,000 from somewhere to plug the gap or forfeit the property. If they get stuck with option two, they’d better hope they haven’t paid a 10% deposit and waived their cooling off rights.
Had Sarah and Tom gone with Lender B who doesn’t reassess at the point of unconditional approval, they would have been able to proceed with the $500,000 loan.
So how do you get it right and not lose your money?
Easy. Talk to a broker. Mortgage brokers know which lenders will honour your pre-approval assessment and which won’t. And if you go with a lender who won’t, they can update your borrowing capacity calculation for you each time there is a rate rise so you know exactly where you stand.