How Do REO and Short Sale Banks Demand a Preapproval Letter From Borrowers?

female banker talking to couple
Eric Audras/PhotoAlto Agency RF Collections/Getty Images

Question: How Do REO and Short Sale Banks Demand a Preapproval Letter From Borrowers?

A reader asks: "As responsible and serious home buyers, my wife and I got preapproved through Wells Fargo to buy a home. We found a home we like but it is a short sale. Our agent says we must get preapproved through the short sale bank to be eligible to buy this home. This is crazy. Why would we want to divulge our personal information to a bank with which we have no relationship and do not want a loan from? Why would we want to have another inquiry on our credit report that could cause a dip in our FICO score? How do these REO and short sale banks get away with demanding a preapproval letter from borrowers? Do we have to get preapproved by them?"

Answer: I can understand your reluctance to get preapproved by an unknown bank when you already have loan preapproval. It makes no sense to you. But that's because you're not on the other side of the transaction. Many buyers whose lenders say they are preapproved are not really preapproved.

You might wonder how can that happen? How can a bank issue a preapproval letter that is a big fat lie? Very easily. They exclude certain pieces of information in the letter itself and make those exceptions contingencies. Moreover, not all preapproval letters are an actual preapproval. There is a difference between a prequalification letter, known as a prequal, and a preapproval letter.

The Differences Between a Prequal and a Preapproval Letter

A prequal, which is typically the type of preapproval letters that a mortgage broker might issue, state the following types of documentation:

Prequalification Letter:

  • The borrower has applied for a loan.
  • Credit report has been checked.
  • Based on information supplied, the borrower is qualified to buy a home at a predetermined maximum price.

Preapproval Letter:

  • The borrower has completed a loan application.
  • Credit scores are pulled and sufficient.
  • Employment has been verified.
  • Borrowers have submitted supporting documentation such as tax returns and bank statements.
  • Borrower is preapproved to buy a home at a predetermined maximum price, pending an appraisal and title policy.

You can see that a true preapproval letter carries a lot more weight. But it, too, is subject to final underwriting and is not a guarantee. It is subjective and dependent on more documentation and scrutiny.

Why a Short Sale Bank Would Ask for a Preapproval

The short sale bank, prior to approving a short sale, has a lengthy process to go through. The bank will hire a BPO agent to assess the value of the property. It will assign negotiator. It could take weeks or months to reach a decision on the short sale.

Here are some facts about short sales to consider:

  • The short sale is a privilege -- it is not a right of either party.
  • The bank has typically little incentive to approve the short sale.

Not only does the seller and the property generally need to qualify for the short sale, the borrower needs to be qualified to purchase the home. The bank that is processing the request for the short sale wants definitive proof that the buyer is capable and qualified to close.

The truth is after working on a short sale for weeks, maybe months, it is a huge disappointment and waste of time if the bank discovers at the end that the buyers cannot close.

When it gets down to the wire and into underwriting, sometimes a buyer's loan will blow up. Some of the things that cause the buyer to be rejected could have been corrected or spotted in the beginning but were not.

That's because there is not enough regulation over the issuance of preapproval letters, and not every lender uses standard procedures. For example, a FICO score of 720 is generally required as a minimum for a conventional loan. But the major lenders who make conventional loans often prefer a higher FICO minimum of 740 to grant an attractive interest rate to the borrower.

If a borrower believes the lender will offer its best rate for a FICO of 720, there is a potential for conflict that could cause the transaction to cancel or the borrower to be rejected. The short sale bank simply wants to check the information for itself and make its own determination as to whether the buyer is fully qualified.

It is against RESPA regulations for a bank to demand that a borrower obtain a loan from that bank. However, it is perfectly acceptable for a bank to demand a preapproval letter from its own bank before approving the borrower for the short sale or allowing the borrower to buy its own bank-owned home.

Sometimes, a bank will let a borrower submit a DU (desktop underwriting) in-lieu-of a preapproval letter. It's worth it to ask.

At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.