What are the hidden risks of buying with auction finance pre-approval?
One of the Loop Financial Big 6 client questions, this time on auction finance pre-approval.
With property in many areas in high demand at the moment, the auction market is hot and sellers (plus real estate agents) are taking full advantage of the situation! Auction finance pre-approval might sound like a good idea, but you need to know the risks.
As a buyer of course, there are financial risks involved with purchasing a property but more so when the property you want to buy is going to be auctioned. For a start, it’s easy to get carried away in the heat of the moment (determined to outbid your competition) where you can end up paying far more than you’d ever intended (or even budgeted for!). But there are also other hidden risks that are catching many buyers out and leaving them in an impossible financial situation.
Lauren Mamaj, Finance Strategist and Chief Number Cruncher at Loop Financial, says “The most common issue we find is the misconception or false confidence that is placed on finance pre-approvals (more often than not), when an auction finance pre-approval is not worth the paper it’s written on!”
So before you head out all gun-ho to buy a property with a pre-approval (or even consider bidding at an auction), you need to be aware of the risks so you’re not left high and dry when D-day comes and you need to actually come up with the money to pay for the property.
What is an auction finance pre-approval?
An auction finance pre-approval is the first step where mortgage providers can give you an indication of what you can potentially afford to borrow and at what Loan to Value Ratio (LVR) to purchase price.
A Loan to Value Ratio is calculated based on how much money you have to contribute to the purchase e.g. savings and/or equity as well as your borrowing capacity based on income and expenses in line with the lender criteria e.g. some lenders will consider lending up to 95% of the purchase price if you can meet their lending policy requirements.
So, if you pass this initial qualifying criteria on LVR and borrowing capacity, hey presto, you have yourself a pre-approval! But, what most people are not aware of is that a pre-approval is still subject to many terms and conditions and these can be written in a complicated way in teeny-tiny writing (and ain’t nobody got time for that!). Disclaimer: we totally recommend you read ALL the fine print, even if it takes a week!
So whilst there is definitely some value in obtaining an auction finance pre-approval (to know what purchase price is possible before you hit up www.realestate.com.au), it is by no way a formal commitment by the lender you will be actually be fully approved for finance.
What kind of conditions are usually listed on an auction finance pre-approval?
You will probably find the fine print says your auction finance pre-approval is valid for 90 days from the date issued. It will be based on the current information supplied and subject to review should any of your financial details change; including employment, income, liabilities and asset position.
It will also state that the approval is subject to ‘acceptable security’ with ‘security’ being the thing that your lender is securing your loan against, i.e. the property. To keep it simple, the mortgage provider who will be lending you the money, needs to ensure that not only can you afford to repay the loan, but the property that they will be securing finance against is also a good asset should something go wrong. Security and lending value rules are critical components to the successful assessment of any finance application.
For instance, size is important; most banks prefer the property to have a minimum living area of 50 square meters and this often doesn’t include balcony, outside courtyard or car space.
Banks can also set a limit on their exposure of a particular building or development that they are prepared to lend money on to reduce their overall risk. For example, say this is capped at 25% for an apartment block of 200 apartments, then they will only lend on up to 50 of those apartments. If the one you want to buy is the 51st they receive an application for, then it’s just tough luck!
Frustratingly, every bank sets different rules and limits, not all of which are available to the public, so nothing is guaranteed until after they’ve reviewed a full application submission as well as completing a valuation the property.
“Pre-approvals are an area to be cautious with and just because you’ve passed the initial step, doesn’t mean the finance will be fully approved,” says Lauren Mamaj, Finance Strategist and Chief Number Cruncher at Loop Financial. “We’ve heard the horror stories where a client has gone to auction armed with a pre-approval (issued by their bank), they have bid successfully, and come back all excited to their bank for full approval and have then been declined because they couldn’t satisfy all the conditions required”.
To give you an idea of what a pre-approval would look like, check out this example.
What can go wrong with an auction finance pre-approval?
A lot of things! According to Lauren, the frustration is that not many banks or mortgage brokers actually explain what ‘could go wrong’ and how to avoid or reduce the risks until AFTER a client has purchased, which is of course too late!. “I hate being the doom and gloom and the “warning, warning, warning”, but I’m always of the opinion that the more you know and understand your risks, then you go out there with your eyes wide open and are prepared for worst case scenarios” she says. “This is why we work with our clients before they decide to buy to eliminate or reduce as many finance risks as possible, as well as exploring Plan B’s should the worst case scenario actually happen!”.
What are the common reasons an auction finance pre-approval would be declined?
First, a pre-approval usually has not been fully assessed by the lender or credit department and your supporting documents have not been verified or assessed in line with bank credit policy.
So, if you find a property at a price that meets all the headline requirements as set out on your pre-approval, you can still be turned down for full approval for a number of reasons:
- You can’t provide satisfactory evidence of your
- Your financial situation has changed, for example you have recently changed jobs or reduced your working hours or income
- You have applied for another credit card or loan which has reduced your credit score and impacted chances of lender approval
- The lender credit policy has changed and you do not qualify under the new criteria
- Interest rates have increased which impacts what loan amount you would qualify for
- The property valuation is unacceptable security to the lender
- The Loan To Value Ratio is reduced due to a higher risk security or application and you do not have sufficient equity/savings to complete the transaction
- The LVR requires Lenders Mortgage Insurance and you do not meet their stricter criteria
Basically, if you can’t satisfy the conditions listed on your pre-approval and provide the relevant supporting documentation to evidence you meet the credit policy (including Lenders Mortgage Insurance if required), you will be declined for full finance approval.
How can you reduce your risk buying with an auction finance pre-approval?
Lauren explains that there are definitely steps you can take to reduce the risk of buying with a pre-approval and recommends private sales (not auctions) as a sure fire way you can potentially negotiate a ‘get out of jail free card’ by having a ‘finance clause added to the contract”.
Even though the auction market may be hot (and it seems there is absolutely no way you can find a private sale), you can also work with a Buyers Advocate who may be able to help you. A good buyer’s agent can find out about sales before they go on the market, so played correctly you may be able to negotiate an off-market transaction (or private sale) and even include a finance clause.
“A finance clause protects the purchaser should their pre-approval not progress to a formal approval for whatever reason. Most finance clauses can be negotiated at 5-10 business days, which allows time for the bank to value the property and then complete their final credit assessment on your application”, Lauren explains.
So, why someone would consider selling a property off the market (with a finance clause) and not take it to auction if the market is red hot? They may want to avoid a lengthy advertising campaign and the costs associated with this. It could be due to the sheer inconvenience of scheduling multiple open for inspections, OR they may need a super-fast settlement due to a marriage breakdown or loss of a family member. Negotiating off-market can often be a faster process, especially when their real estate agent has a connection with a Buyer’s Advocate who has qualified purchasers ready to buy.
However, if you still plan on rolling the dice and putting your hand up at an auction with your pre-approval, you need to be fully aware that you cannot have any conditions or finance clauses added to the contract. When you bid at an auction, you make an unconditional and legally binding agreement to complete the purchase.
What can you do to reduce the risks when buying with a finance pre-approval
If time allows leading into the auction, a fully qualified mortgage broker or finance strategist can also dig deeper and complete a more thorough assessment of your financial position including:
- An updated Preliminary Assessment based on your current situation and whether you still meet the parameters as set out on your original pre-approval. For example, is your financial position exactly the same as when the pre-approval was issued? You may have changed jobs and also updated your car by taking out a car loan, and this now effects your borrowing capacity. Your original savings may have also reduced and this now impacts the loan amount and potential purchase price you would qualify for.
- Knowing your Credit Score gives you insights to help make yourself more attractive to lenders, so you can check this yourself or your mortgage specialist should have access to do this for you without leaving a footprint on your credit file. This handy sneaky peak can be extremely valuable in understanding where you rank and the likelihood of approval based on your credit score before you submit an application. There are also some lenders who do not credit score, so again this is where partnering up with an experience mortgage specialist can help you navigate which lender would be suitable (ultimately, sourcing lenders for your best chance of approval!).
- Postcode checks to determine whether the property location is acceptable as well as lender exposure levels on a particular development, property size and zoning usage are other areas which may be of concern to the lender you have the pre-approval with. These can always be checked prior to attending an auction and your mortgage specialist can provide you the advice on areas you will need to be aware of so you can then adjust your search and minimise risk on not achieving formal finance approval. Again, while the pre-approval you have with one lender might not accept the security in the postcode you are considering, another lender may give it the green light!
- A Property Profile report can also provide an indication as to the potential market value and give you a guide on whether the price point is within your pre-approved limits. This report can provide up to date recent comparable sales so you know what other property has sold for in that area. Again, your mortgage specialist should have the access and resources required to be able to provide you a report on the property you are considering to buy.
You can also arrange for a pre-auction valuation which will give you an actual true assessment of the market value and flag any potential issues that might render it unacceptable as security to the bank. Lauren recommends to then have the valuation reviewed by a finance industry expert who will apply their knowledge and skill set on whether or not the property is likely to be accepted by your finance provider as well as to explore what other lender options may be available.
Just as one lender may deem the property unacceptable, another may find it acceptable and this is where aligning with a mortgage specialist will be your greatest resource (Sometimes it comes down to who you know!)
Lauren recommends you also complete thorough due diligence on the auction property and ensure you have a licenced conveyancer and or solicitor who can complete relevant checks including a full review of the Section 32 and Contract of Sale.
What if your auction finance pre-approval falls through after the auction?
Remember, when you bid at an auction, you make an unconditional and legally binding agreement to complete the purchase. So, if for some reason your finance falls through, you’re still liable for the contract. (Yep, not a good position to be in!)
The vendor wants to get paid and really doesn’t want to hear your sob story so this means no matter what, you need to find the money to settle on that contract or you could be sued for the full contract amount (Yikes!)
Lauren cites a classic example where a couple wanted to buy their first home, so they went to see the manager of the bank they’d been banking with for “donkey’s years”. They had an excellent banking history, great income and a good cash sum saved up for a deposit. The bank manager entered all of their information into the system and soon handed them a document with details of their pre-approved loan amount and what purchase price level they could afford.
The couple then went off (all excited) to buy a home at auction but when they came back to the bank manager to get the full approval, they found out that there was extra credit assessment required which they hadn’t been made aware of (even though it would have been written on the pre-approval in teeny-tiny writing!).
Because Lenders Mortgage Insurance was required, their initial pre-approval was subject to another tougher level of credit assessment. Unfortunately, when their application was submitted for full approval, it was then declined by the mortgage insurer as they didn’t meet their policy or lending criteria.
“They were then recommended to come to us for help and you can imagine how stressful and panicked that initial phone call was! What should have been such a happy & exciting time – buying their first home – became a nightmare where they were left wondering whether they were going to get a home at all. We reassured them that by having access to other lenders and other mortgage insurers, we were experienced in finding one that would be suitable to achieve the finance approval” says Lauren.
If you do find yourself in this tricky situation, committed to a property purchase and struggling to achieve formal finance approval, you might want to get a second opinion from a mortgage specialist and let them exhaust all possible options before you hit the panic button!
Worst case, if you still can’t achieve finance approval, you may be able to cut your losses by selling the property on again within the settlement period (Often referred to as flipping). You’ll probably have to accept a lower price to get a quick sale and potentially be subject to capital gains tax, double stamp duty and agent fees, but it may be a lesser price to pay versus being taken to court! (We strongly recommend you speak with your accountant beforehand on any tax and financial implications by implementing this strategy).
Of course, the safest way to bid at auction is to have the cash ready ahead of time, or have your finance fully approved. If you’re only at the pre-approval stage then it’s far safer to look for a private sale or engage a buyer’s advocate who will make sure the contract has clauses that protect you. The most important one is to have a finance clause that gives you a way out of the deal if your mortgage pre approval falls through.
“There are a lot of areas where you can negotiate on with a private sale if the price is right and you have met the vendor’s requirements. Whereas at an auction, you pay the price and you’ve got the property.” This is why sellers (and real estate agents) love auctions. Once the hammer goes down, the transaction is unconditional and the buyer must meet the settlement date.
How Loop can help out with auction finance pre-approval
In her 16 years working in the mortgage finance industry, as well as building a substantial investment property portfolio herself, Lauren’s passion is that her clients are fully informed and can then make educated financial decisions. The Loop team help clients to avoid the risky situations of buying with a pre-approvals but they have also rescued others who have bought a property and then found out they couldn’t secure full finance approval from their bank or mortgage broker.
Lauren and her team at Loop and are committed to reducing the risks and informing all clients of their options. An example of this is where a client was issued a pre-approval and was having a hard time finding a private sale. They then wanted to buy a property at auction and Lauren explained the risks and the ways in which they could work thorough reducing and eliminating as many as possible before the auction. The Loop team also helped in researching other suitable lender options as a backup plan, just in case the original lender pre-approval could not be converted to full approval.
Lauren says that the client was very appreciative that she could go into the auction fully informed of the risks and knowing that she had a plan B. It was about understanding what could go wrong and being prepared for the worst-case scenario. There is a happy ending to this story where the buyer managed to secure the property at auction and the Loop team achieved the full finance approval. But Lauren likes to stress that sometimes, it’s not all smooth sailing.
Finance and credit policy amongst the banks does change (often with little to no warning…) and the Loop team recommend you are aligned with a mortgage specialist that is on the ball and up to date with any regulatory and credit policy changes. They can explain any potential risks on your pre-approval and adapt and shift lender options as needed.
“The main benefit of a mortgage broker is that they have access to a panel of lenders, not just the big four”. Each bank has only their products and credit policy to work with and so if you don’t fit this then you will be declined. An experienced mortgage broker can direct and advise you on which lenders credit policy you will actually meet versus shopping for the lowest interest rate! Yes, interest rate is an important factor but it may be that your preferred loan provider has a great rate on offer, but very strict terms that you just can’t satisfy to achieve the approval. The Loop team work hard to research lenders that will fit your requirements and whose requirements you can fulfil to ultimately to achieve full finance approval. This saves you the time and headache of having to research online or contact each bank yourself.
“That’s the value of working with an educated mortgage broker who not only has a vast panel of lenders that they are accredited and experienced in working with, but also the skill set to analyse which lenders may or may not suit. They can research more product options (and loan suitability and credit criteria) compared to a bank who can only offer their products, which is subject to their own assessment and approval criteria,” she says.
So if you’re thinking of buying at auction or want to have the best possible chance of getting your finance approved, then get in touch with Lauren (or another member of the friendly team at Loop Financial), who can arm you with all the knowledge to buy with confidence.
Disclaimer *Your full financial situation would need to be reviewed prior to acceptance of any offer or product.
Credit Representative Number 482730 is authorised under Australian Credit Licence Number 389328.