Lately, I’ve been getting panic calls from real estate buyers (or their Realtors) to inform me that their bank was not honouring their mortgage pre-approval. Pre-approvals have been failing more and more frequently. Obviously, this creates tremendous stress for the buyer and Realtor, and this situation is becoming more and more common.
Why is this happening?
It’s simple. There is a huge misconception about what a “pre-approval” means. Most Canadians (and Realtors) know that you should get pre-approved before making an offer to purchase real estate. They believe the pre-approval means the bank is guaranteeing a mortgage. Nothing can be further from the truth.
So what is a pre-approval?
A pre-approval is basically an interest-rate hold. It means you applied for a mortgage and the bank will honour the current rate for a few months. Perhaps they quickly reviewed your application to check if you’re employed. Maybe they briefly checked your credit, however, this is not done every time.
So why does a pre-approval fail?
Generally, a pre-approval is rejected when the income documents submitted do not perfectly match the application. It can also fail when the property has ‘problems’. Unfortunately, this is happening more and more often.
Why are income documents failing?
Twenty years ago, a married couple might have purchased a house. Maybe the husband was a teacher and the wife was an accountant. They each made $50K per year and they had been working at their jobs for 10 years. Easy, breezy. Today, many borrowers have complex income situations. For example, a borrower might rent out his basement, paint houses (for cash!) on weekends or work a lot of overtime. They might even have a full-time and an additional part-time job. When he says he makes $100,000, he is not lying. He works hard and has several jobs because he knows real estate is expensive. He did the right thing – he got a pre-approval.
Nevertheless, banks don’t think the way that we do and they’ll want a consistent track record of that income. He’s getting paid in cash and he’s only been doing that for 9 months. His income from painting cannot be included. His basement apartment isn’t a “legal” unit and he’s not declaring it on his taxes. Plus, he works a lot of overtime but the overtime isn’t guaranteed. Therefore, according to the bank and his paperwork, his income is only $35,000. This discrepancy should have been identified earlier.
If the application had been reviewed by a mortgage professional with a detailed understanding of lender policies, the situation could be resolved. This is rarely the case. The borrower who had a pre-approval for $500,000 based on his $100,000 income can now only qualify for a mortgage of $150,000 based on his $35,000 income. Uh oh. This borrower might be eligible for a mortgage from a different bank. The challenge is the interest rate may be much higher. The rates are higher because he needs a lender that will look at income beyond their tax returns…
Believe it or not, this issue can surprise wealthy borrowers too. Imagine a doctor, accountant, lawyer who incorporates their business. They pay themselves a low salary to minimize taxes. They might “earn” $500,000 and include this income on their application. Many lenders will only consider their personal income.
But this isn’t the end of the story – the property could have issues too…
Pre-approvals are also failing due to issues related to the property. The most common issue is the appraised value. If you made an offer of $700,000 and the appraiser assessed the value at $600,000 – the bank will not give you a mortgage based on the purchase price. The mortgage will be based on the $600,000 valuation and the borrower will need to come up with an extra $100,000 in addition to the down payment. Yikes.
Many buyers who purchased a property in Toronto in March/April but ordered the appraisal in July are in trouble. A good mortgage professional will try to appraise the property as quickly as possible to mitigate the risk of market timing. Buyers who purchased a property in Oct-Dec with a closing in 2018 should also request a rush appraisal in case the market changes in early 2018.
The appraisal isn’t the only reason that pre-approvals fail. Many of you have heard about condos where the windows/balconies are falling out – which will likely lead to lawsuits, special assessments and issues of marketability. I wouldn’t want to lend someone 95% on a condo where the building has falling windows, would you? Other issues include hotel/condo hybrids, which many lenders avoid. After all, there could be some monkey-business between how the hotel accounts for common expenses versus the condo corporation.
Other areas to be aware of are co-op apartments, or condos with lawsuits or underfunded reserve funds. Of course grow-ops and drug labs are a big no-no. Oh, and here is a cool secret. Believe it or not, some lenders have a “blacklist” for condos they will not lend on. It will be difficult to get a mortgage if your condo is on a blacklist. And this blacklist exists, but is not published! (It’s also not called a blacklist for legal reasons!)
What about freehold properties?
They can fail too… If you are pre-approved, but you bought a house that was a marijuana grow operation, it is unlikely the bank will honour the pre-approval. Mortgages can fail also if the house is not in ‘livable’ condition. Some examples include mold, leaky basement or structural or environmental issues (UFFI, Kitec plumbing, knob-and-tube wiring, asbestos, the list goes on-and-on!)
Pre-approvals can even fail based on the down payment
Anti-money laundering and anti-terrorism laws drive documentation of the down payment. Banks want to know about large deposits! Pre-approvals can also fail with an insufficient or ambiguous source of the down payment. Everyone “knows” that you “only need 5% down” to purchase a property, but this is false. First of all, this is only for well-qualified applications. Second, the maximum purchase price is $999,999. Third, the down payment requirement is actually 5% on the first $500,000 and 10% on the next $499,999. So if your purchase price is $999,999 – you need 7.5% down. Plus, and most importantly…
You also need have the closing costs, which could include costly land transfer taxes and other fees! This might lead you to “borrow” some money from a friend or a credit card, but the bank will quickly ask you for the deposit source. If the source is unclear or not a direct gift from family, they will assume the deposit is a loan or cancel the mortgage entirely. Furthermore, banks generally will not permit gifts on a rental property – and a down payment of 20% is almost always required.
Finally, if the situation of the borrower changed since the application, the pre-approval can be rejected. For example, if you quit your job to start a business or even if you quit and found a better job and you’re on probation, you might have a problem. And good luck to you if you leased/financed a car, co-signed another loan or applied for new credit!
In summary, and very simply, pre-approvals should be illegal in Canada, because they give consumers a false sense of security to purchase the largest investment in their entire life. Many Canadians have been burned by this advertising lingo and it needs to change to add transparency and to inform and protect consumers.
What’s the solution?
The solution to this problem is simple. Lenders need to change the “Pre-approval” terminology and call this process a “Simple Rate Hold”, because it accurately depicts the essence of the document. Otherwise, they should clearly document the common methods that a pre-approval can fail, so that buyers make their decision with eyes-wide-open.
The next question is, how do Canadians prevent issues on their pre-approvals? First, I recommend ensuring your income documents are properly reviewed by a qualified mortgage professional – not a part-time “order taker”. Don’t “forget” to tell your mortgage professional that you own another property or that you’re about to lease a car. They will find out and then your mortgage could be revoked! Second, be aware of the limitations of pre-approvals. It is not a guarantee at all, so do your due diligence. Finally, where possible, make the offer conditional on financing. A condition on financing was impossible in the spring market, but sellers are much more willing to accept a condition in the slower market today.
Thanks for reading my blog and stay tuned for more mortgage rants. Please share this with your friends and colleagues!
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Elan Weintraub earned his BBA and MBA from the Schulich School of Business, where he graduated in the top 3% of his graduating class. He is a director and mortgage broker at Mortgage Outlet, one of the “Top 75 Mortgage Brokerages in Canada” according to Canadian Mortgage Professional Magazine. Elan has delivered numerous mortgage seminars at the Toronto Real Estate Board, real estate brokerages and to investor clients and works with clients ranging from first-time buyers to new-to-Canada to bruised credit to sophisticated investors and commercial/construction projects.
The Canadian Mortgage Rant. This blog highlights trends and tips for intermediate and advanced real estate investors, Realtors, lawyers and the daring first-time buyer! Read my other blog posts at mortgageoutlet.ca/blog or my commentary on the new OSFI stress test at http://mortgageoutlet.ca/2017/10/17/will-osfis-new-mortgage-stress-test-help-hurt/