Many lenders are taking a number of weeks (sometimes months) to approve loans at the moment. These delays have been caused mainly by significantly higher mortgage application volumes and the operational disruption from onshoring back-office services due to Covid lockdowns in the Philippines and India.
As such, banks are prioritising applications for borrowers that have already purchased property and have a definitive settlement date to meet. Consequently, pre-approval applications are low priority and can take a long time to arrange. This blog discusses the pros and cons associated with buying a property without a loan pre-approval.
What is a mortgage pre-approval?
A pre-approval is a conditional loan approval. Typically, the main condition is that the borrower is able to offer a suitable property as security for the proposed loan. For example, a bank may approve a loan for $800,000 subject to the borrower buying an acceptable property that is valued by the bank at an amount of at least $1,000,000 (to keep the loan to value ratio at 80%). The only other condition might be that the borrower’s financial circumstances do not change. This is called an approval-in-principle (AIP) or pre-approval.
Arranging a written pre-approval with a bank (via a mortgage broker), gives borrowers a higher level of certainty that, if they go ahead and purchase a property, that the bank will ultimately unconditionally approve a loan to fund that property.
Pre-approvals do not attract any fees (they are free) and you are not obligated to use that lender or borrow the pre-approved amount.
What could go wrong even if you have a pre-approval?
Things can still go wrong even if you have a pre-approval.
Typically, the only material risk is that the bank values your new property below the purchase price. The bank will lend against the contract price or valuation, whichever is lower. If the property valuation is lower than purchase price, it will mean you won’t be able to borrow as much and you must contribute more cash (or additional property as security).
For example, if you buy a property for $1,000,000 and need to borrow 80% (or $800,000), and the property valuation comes back at $950,000, the bank will reduce your loan amount to 80% of that value, being $760,000. That means you must contribute another $40,000 of cash to be able to settle on the property.
The other risk is a change in circumstances (such as losing your job) occurring between when the pre-approval was issued and when the loan is ultimately formally approved. Of course, if your circumstances change before you have purchased a property, you should go back and speak to your bank or broker. If your circumstances change after you have purchased but prior to a loan being fully approved, that could be problematic, although this is very, very rare.
Are low valuations common?
No. By definition, the value of a property is what the market is prepared to pay for it. Therefore, if you have purchased a property in a standard open-market sale, that is usually strong evidence of its current market value.
However, if there are not enough sales of comparable properties to support your purchase price, that is when a low-valuation becomes a risk.
It is possible to challenge a bank valuation by providing additional evidence, but this usually has a low success rate for a variety of reasons. In our experience, the most expedient solution is to go to another bank. More often than not, alternative banks (which means alternative valuers) will value the property at contract price.
However, if you have genuinely overpaid for a property, then obtaining a bank valuation equal to contract price will be challenging.
You need to know what you do not already know?
Some potential borrowers use logic to determine the likelihood of a bank approving their loan. They may reflect on the fact that the repayments are easily affordable and assume the bank will agree. That is a flawed approach because sometimes (often) bank credit policies often lack logic. Just because you feel you’re a low risk, doesn’t mean the bank will agree.
Banks use compressive credit scoring models in order to assess an applicant’s credit worthiness. If your application scores low, it will be declined. There are lots of things that impact a credit score, some of which most laypeople would consider to be inconsequential.
The other common ‘unknown’ is what is on your credit file. For example, there might be a bill that you were never aware of that wasn’t paid. Or it could contain errors. These things can cause issues.
These risks can be identified and mitigated by arranging a pre-approval.
Do all pre-approvals reduce your risk?
There are two types of pre-approvals.
The first type is where the application goes through the same credit approval process as a full application. That is, a human credit assessor reviews the application and verifies the information.
The second type is where the banks system reviews/approves the pre-approval, but no one verifies the data that is put into the system.
Of course, the second scenario is highly dependent on the information that is entered into the system. If there is any ambiguity or subjectivity to the data, the second option doesn’t really reveal how the lender will assess that information, and is therefore less valuable.
Is it risky buy without a pre-approval?
The answer to this question depends on the strength of your financial position and circumstances. Typically, we would consider two main factors:
- How much you need to borrow compared to your maximum borrowing capacity. For example, if we were advising a client and we assessed that they could borrow up to $2 million. However, in this instance, they only need to borrow $500,000, then we might conclude a pre-approval is not critical. However, if we need to borrow close to a client’s maximum, then even a small change in a lender’s assessment could have an adverse impact. As such, we’d recommend the client obtain a pre-approval.
- Our assessment of the likelihood of approval. After almost 20 years of experience, we have a very good sense about whether a bank will approve a loan. Included in this assessment is considering the level of subjectivity in the bank’s credit assessment. If a client’s situation is not clear-cut, it increases the risk that a bank may not agree with our assessment. Of course, we would never advise a client to take unmitigated risks. But if we are almost certain that we can get a loan approved, a pre-approval is not as imperative.
In some situations, we might have a high level of certainty that we can get a loan approved by one of the 30+ lenders on our panel, but it’s not as certain that the clients preferred lender would approve it. In this situation, we would invite the client to make friends with the worst case scenario – that is, if their preferred lender declined the loan then we would need to use an alternative lender. Often the differential in interest rates and fees, if any, are not material, as the mortgage market is competitive.
How experienced is the banker or mortgage broker advising you?
If a mortgage broker or banker advises you to purchase a property without a pre-approval, you must assess their experience and aptitude before relying on their advice. If they have many years or decades of experience and deal with people that are similar to you, it should provide you comfort. However, don’t listen to someone just because they work for a well-known brand. You need to trust the individual, not the brand.
How can you minimise bank valuation risk?
Banks will not value a property before you sign a contract of sale. However, you could engage a firm (same firm that also works for the banks) to prepare a “valuation for mortgage purposes”. This would give you an indication of fair market value, although it’s possible that valuers may be conservative to manage their business risk. However, in my experience, few purchasers get properties valued before they buy them.
Undertaking comparable sales research is probably the best thing you can do to minimise the risk of paying more than the bank’s valuation.
Engaging the services of an experienced and trustworthy buyers’ agent is another way to minimise valuation risk. They will have a lot of experience and knowledge which helps determine fair market value and undertake comparable sales research on your behalf.
Remember, it’s your risk
Buying a property without having a pre-approval is not without risk. Of course, the risk is acceptable in some situations but unacceptable in others. A highly experienced mortgage broker will be able to guide you with this decision, as they will be able to draw upon their experience with multiple lenders. However, ultimately, if you decide to purchase without a pre-approval, it’s your risk.
Of course, I do acknowledge that sometimes circumstances do not allow you to obtain a pre-approval, even if you wanted one.
This is why investing is more a game of finance, than a game of assets (property or shares). And an experienced team of professionals (buyer’s agent, financial advisor, mortgage broker) can help you win that game.