Money Mondays: The Week Ahead in Financial News

July 23, 2007 — -- In the new and ongoing series "Mellody's Money Monday," Mellody Hobson gives a financial roundup of the hot topics everyone will be buzzing about this week.

This week she tackles mortgages, the Dow and gas prices.

1. With foreclosures up 56 percent from last year, what traps can would-be home buyers avoid?

The most important thing is to be realistic about how much home you can afford. I often hear about how people use online mortgage calculators to determine what they can afford. While these calculators can be a good starting point, they are not a panacea. They do not always include property taxes and home insurance — additional expenses that will increase your monthly mortgage payment — and most do not include the cost of private mortgage insurance, which you will need if your down payment is less than 20 percent. Calculators that take into account the costs of property taxes and home insurance generally only include average amounts, such as annual property tax of $3,500 and homeowners insurance of $868, which may not be nearly as much as what you actually need to pay on your home. So, while online calculators can offer you a ballpark figure, it is essential to understand and take into account their limitations.

2. What about prequalification and pre-approval letters? Are they useful?

A prequalification letter is simply a document from a mortgage lender that states you are a "qualified" home buyer and estimates what you can afford. Often, to get a prequalification letter, the potential buyer only needs to provide basic financial information, such as income, assets and credit, and this information is not always verified (as it is when you actually apply for a loan). The obvious downside is that you may end up coming away with an inaccurate picture of what you can afford. And, as the old adage goes, if it sounds too good to be true, it probably is. Pre-approval differs from prequalification in that it requires a more thorough evaluation, including a complete credit check and specific financial documentation. A legitimate pre-approval letter will state that it is not a binding document, that the loan is subject to the appraisal of the property and that the interest rate quoted could vary. Although pre-approval goes a step further in terms of helping you determine how much mortgage you can qualify for, there are no hard and fast guarantees.

3. So, can these letters actually be harmful to potential home buyers?

Absolutely. Cases of unscrupulous lenders using this type of document to give buyers a false sense of their net worth leading them to buy more home than they can afford are on the rise. In fact, a recent study done by a communications firm in Washington, D.C., found that almost 40 percent of pre-approvals issued by Internet-based lenders and 30 percent from mortgage brokers are incorrect or invalid. The bottom line: If a prequalification paints a rosier financial picture than you were expecting, be wary. The more complete pre-approval process can be helpful in providing you with a better sense of the amount you can spend on a home, but it is equally important to do your own number crunching.