Mortgage advisors are constantly urging borrowers to “Get a pre-approval.” What they don’t tell you is that a pre-approval usually comes with a premium.
Is a pre-approval worth the extra rate cost?
First off, what is a mortgage pre-approval?
A pre-approval is when a mortgage lender grants a conditional approval based on a preliminary evaluation of the borrower’s qualifications.
One of the key benefits is that the borrower can lock in a rate at the time of the pre-approval, typically for up to 90 or 120 days.
Pre-approvals also let a borrower know roughly how much mortgage they can qualify for.
What a pre-approval is not is a firm mortgage approval. That’s because, in most cases, the lender must still verify much of the applicant’s credit, property income and down payment information once the application turns live. (“Turns live” means the borrower has signed a purchase agreement and has a specific closing date.)
Rates are based on a home value of $400,000
The rate premium on pre-approvals
Pre-approvals have benefits, no doubt. But they usually come at a cost.
In general, count on a pre-approval adding anywhere from 0.10 to 0.25 percentage points on top of your rate.
To put 0.25 percentage points into dollar terms, it works out to a difference of roughly $36 in monthly payments, or $3,500 in interest cost over a 5-year term. (That’s based on a 25-year amortization and $300,000 mortgage, the average mortgage balance according to TransUnion).
So, why do lenders charge more when a pre-approval is offered? It all comes down to the extra cost they incur.
For one thing, pre-approvals give borrowers options. The borrower is not obligated to close the mortgage.
As such, people often use pre-approvals as free insurance policies against rate increases and don’t end up closing. In fact, only about 15-35% of pre-approvals close, depending on what rates do.
Despite that, lenders still have to hedge pre-approval rates so they don’t take undue rate exposure – i.e., so they don’t lose a tonne of money if rates soar.
In other words, if a borrower has secured a pre-approval at 2% and rates surge to 2.75%, the lender must still honour the 2% rate, despite now facing much higher funding costs.
That’s why lenders rarely give the best rates on pre-approvals. But it doesn’t mean you shouldn’t get one. Pre-approvals are mandatory if you’re going to take a while to find a home. That’s especially true in a rising-rate environment like we find ourselves in today.