But The Lender’s Letter Said The Buyer Was Pre-Approved
By David Hamerslough
September 15, 2021
Providing the seller with a pre-qualification/pre-approval letter is a contractual requirement for buyers whose offers include a financing contingency whether the offer is written on a PRDS or a C.A.R. form. Even in some situations where the offer is not contingent on lender financing, many buyers provide pre-qualification/pre-approval letters to demonstrate that they are financially capable of purchasing a property. This is especially true where the buyer intends to obtain lender financing but they are willing to take the risk of not securing that financing by writing a non-contingent offer.
Historically, pre-qualification and pre-approval letters differed in regard to what steps a lender had taken prior to stating that the buyer qualified for a loan. One common distinction between a pre-qualification letter and a pre-approval letter is the degree of investigation undertaken by the lender. Traditionally, with a pre-qualification letter, the lender has merely collected some basic financial information from the buyer to provide an estimate of how much the buyer can afford. Pre-qualifications often rely on self-reported information, and generally the lender has not verified the buyer’s information by pulling the buyer’s credit report or reviewing financial documentation. Generally, before a lender would issue a pre-approval letter, the lender would want some verification from the buyer as to their financial status, such as a loan application and backup financial documentation.
Unfortunately, the exact steps undertaken by the lender and/or the language used in creating these letters can change from lender to lender, and, at times, it has appeared that the words “pre-qualification” and “pre-approval” have been used interchangeably. Given the differences in what lenders require for pre-qualification vs. pre-approval, it is difficult for the real estate industry to use these terms with any precision. It is therefore important to look to what the purchase contract actually requires when determining whether any such letter could be used by the buyer to meet their contractual obligations and/or whether the document should relied upon by the seller.
The PRDS contract requires a pre-approval letter, while the C.A.R. contract allows for either a pre-qualification or a pre-approval letter. Given the criteria in both contracts for such letters, the inclusion of the term “pre-qualification” in the C.A.R. contract may have less significance than the general distinctions between the types of letters that these terms have historically implied. This article will continue to refer to all such letters as “pre-approval letters.”
The PRDS and C.A.R. contracts (including the revised C.A.R. contract to be released in December of this year) require that the pre-approval letter (1) be issued by a lender or mortgage broker, (2) be based upon a review of the buyer’s application and credit report, and (3) state that the buyer is pre-approved for the loan(s) or new loan specified in the purchase contract. If the paragraph that requires an identification of loan terms does not indicate the type of loan (e.g., fixed vs. adjustable) or does not specify an interest rate cap, there will be no way to compare the terms of the pre-approval letter with those in the contract. Thus, it is imperative that if there is a financing contingency, information about the loan terms must be specified in the buyer’s offer.
There is a distinction between PRDS and C.A.R. when it comes to adjustable-rate loan terms and therefore the terms of a pre-approval letter. The PRDS contract indicates that adjustable-rate loans are based upon the initial fixed rate, while the C.A.R. contract states that any pre-approval letter shall be based upon the initial qualifying rate, not the initial loan rate. In the event that any pre-approval letter fails to state that it is based on the foregoing criteria, it does not meet the requirements of either contract. If the parties are not yet in contract, then this issue can be addressed before an offer is accepted or as part of a counteroffer. On the other hand, if the pre-approval letter is provided after the parties are in contract, then the seller must issue a Notice To Perform to address the inadequacies of the documentation provided.
Irrespective of whether the lender’s letter is entitled “pre-qualification” or “pre-approval”, neither type of document is a guarantee that the buyer will actually receive a final loan commitment, let alone funding of the loan. Therefore, there is no assurance for the seller that the buyer will be able to complete the purchase of the property simply because the buyer has produced the contractually required documentation.
The lender letters set forth the terms and conditions of loan approval; over the years, these letters have become vaguer and more open-ended, all to the benefit of lenders. The significance of the vagueness and open-endedness of pre-approval letters always seems to increase when real estate markets are in transition and/or lenders are concerned about the number of loans already processed and they start to reassess their lending criteria.
The following language from a recent pre-approval letter illustrates this point:
“Final approval will be based on an acceptable appraisal of the chosen property, an acceptable title insurance policy, a full and current approval by the bank of the designated property, your ability to fulfill all of the bank’s standard underwriting guidelines, and provided no material financial change has occurred in your financial condition.”
If I were the seller of a property and I received a pre-approval letter with this language, I would not have a lot of confidence that the buyer’s loan would ultimately be approved. For example, what is an “acceptable appraisal” of the property? What criteria will the lender use to make that determination? To what extent, if any, is that criteria consistent with the language in the purchase contract?
Under the PRDS contract, if the contract is contingent upon an appraisal of the property, the contract requires that the property appraise at or above the purchase price. This requirement exists regardless of whether the buyer is actually seeking a loan or receives a written commitment from the lender for the financing specified in the contract. The current and new C.A.R. contracts also require that the appraised value be no less than the purchase price. The new C.A.R. contract further qualifies this requirement by stating that the appraised value cannot be based on a requirement of any repairs or improvements to the property. Both contracts require that the appraisal be performed by a licensed or certified appraiser.
There is one significant philosophical difference between PRDS and C.A.R. with respect to lender approval and the appraised value of the property. Under the PRDS contract, where there is a loan contingency but no appraisal contingency, if a written lender commitment for the specified loan cannot be obtained because of the value of the property, the buyer has the right to cancel the contract. This is true even if the buyer otherwise qualifies for the loan and the only reason that a loan commitment was not obtained was because the property did not appraise at or above the contract price.
In contrast, the current and new C.A.R. contracts make a distinction between loan qualification by the buyer and the property appraising at or above the purchase price. If there is no appraisal contingency or the appraisal contingency has been waived or removed, then the failure of the property to appraise at the purchase price does not entitle the buyer to cancel the contract pursuant to the loan contingency if the buyer is otherwise qualified for the loan specified in the contract and is otherwise able to satisfy the lender’s non-appraisal conditions for closing the loan. This latter condition is not part of the current C.A.R. contract.
The pre-approval letter quoted above is also vague and open-ended with respect to the following issues:
(1) What is “an acceptable title insurance policy”? Once again, the letter contains no objective criteria upon which this evaluation will be made.
(2) What criteria will the bank be using to make a determination of a “full and current approval” of the property?
(3) What criteria will be used by the bank to determine the buyer’s “ability to fulfill all of the bank’s standard underwriting guidelines”? Is this limited to financial criteria alone, or does it involve some other subjective evaluation?
(4) What if there is a difference between the bank’s underwriting guidelines at the time the pre-approval letter was issued and those that are in effect at the time the bank makes its determination to fund the loan? A bank could easily change its underwriting guidelines based on market conditions without any notice to anyone.
(5) Finally, what defines whether there has been a “material financial change” in the buyer’s financial condition? Without greater clarification of the standards that the lender will be using to make these determinations, the lender’s pre-approval letter could potentially be a worthless document for both the buyer and the seller.
Another issue with pre-approval letters occurs when multiple buyers are making a joint offer on a property and are jointly approved but one of those buyers withdraws as a purchaser prior to the close of escrow. Where this occurs, the pre-approval letter should be reviewed to determine the identify of the party/parties that have been pre-approved. If the financial strength of the remaining buyers is not sufficient for the bank to fund the loan, then the prior pre-approval will have no significance.
Pre-approval can also be impacted by an assignment of the contract. While an assignment under the PRDS contract and the current C.A.R. contract does not relieve a buyer of their obligations under the contract, if an assignment takes place but the assignee does not qualify for any loan, closing the transaction may be in jeopardy, and the parties will be left fighting about the disposition of the deposit. This issue may prove to be of greater significance under the new C.A.R. contract since an individual buyer will have the right, without the seller’s prior approval, to assign all of that buyer’s interest to their own trust or to any wholly owned entity of that buyer that is in existence at the time of the proposed assignment. Whether that separate legal entity is qualified for any type of loan and/or is qualified for the loan that the individual buyer has already obtained could result in the lender refusing to fund the loan which will put the buyer at greater risk of being in a potential breach of contract. This and other issues may arise more frequently under the new CAR language because there is no obligation to get the seller’s approval of the assignment, a process that might reveal the potential flaw in the ability of the new buyer to obtain financing.
The terms and conditions of a pre-approval letter, whether those terms and conditions are consistent with the terms of the purchase contract, and the other issues raised in this article can have significant consequences if they are not properly reviewed and evaluated by both buyers and sellers. These issues often have more significance in a real estate market that is in transition. If we are currently in such a market, buyers, sellers, and their agents should be aware of these potential issues.