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Thursday, July 31, 2014

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Compliance Corner: Second Quarter 2004

Preapproval or Prequalification: What's the Difference?

Over the past decade, many financial institutions have changed the ways in which they accept and evaluate applications for consumer credit, particularly with respect to requests for residential mortgage loans. The use of preapproval and prequalification programs, which emerged in the early 1990s, has become an integral part of home mortgage lending nationwide. Until recently, a common industry definition of "preapproval" as distinct from "prequalification" did not exist, and bankers and mortgage bankers alike often used the terms preapproval and prequalification interchangeably.

Is there a difference between a preapproval and a prequalification, and is it important? Well, for regulatory purposes, the answer to both questions is "Yes!"

Regulation B, which implements the Equal Credit Opportunity Act, was amended by the Federal Reserve Board (Board) through a final rule that took effect on April 15, 2003.1 The regulation's amended provisions, which became mandatory on April 15, 2004, include provisions that govern preapprovals and prequalifications.2

In addition, Regulation C, which implements the Home Mortgage Disclosure Act (HMDA), now provides clear and distinct definitions of both terms. The definitions are part of several changes made to the regulation's requirements for data collection and reporting that became mandatory on January 1, 2004.3

Understanding the differences between preapprovals and prequalifications under both Regulation B and Regulation C is important to avoid inadvertent noncompliance with these regulations.

Preapprovals
Regulations B and C define "preapproval" slightly differently, reflecting the different purpose and scope of the two regulations. However, the Board believes that the two regulations' coverage of credit applications should be consistent, to the extent possible.

Regulation B. As part of the revisions to Regulation B, the definition of "application" has been broadened to include requests for preapproved loans if a creditor reviews the request under certain procedures and practices. Section 202.2(f)(5) of the Official Staff Commentary (Commentary) to the regulation, rather than the regulation itself, discusses preapprovals. In particular, the Commentary specifies that requests for preapprovals are applications when a creditor reviews the request and, subsequent to a comprehensive analysis of the person's creditworthiness, the creditor issues the person a written commitment to extend credit up to a designated amount, for a designated period. Conversely, if a creditor denies a preapproval request following a comprehensive analysis of the person's creditworthiness, then the request for preapproval also constitutes an application and the creditor must issue an adverse action notice to the applicant or person who requested the preapproval.

The Board believes that preapproval requests are applications because they involve requests for extensions of credit made in accordance with creditors' procedures. The fact that a preapproval request is not a completed application is not relevant, because Regulation B also generally governs incomplete applications. However, §202.9(c)(1)-1 of the Commentary to the regulation stipulates that Regulation B's requirement to provide applicants with a notice of incompleteness does not apply to preapprovals that constitute applications under section 202.2(f).

Regulation C. Prior to 2004, a financial institution subject to Regulation C was not required to report preapproved mortgage requests or preapprovals as loan applications on its HMDA Loan Application Register (LAR). However, under the 2004 changes to the regulation, a financial institution covered by Regulation C must report preapprovals for home purchases as applications on the LAR.

Regulation C defines a preapproval request as an application if a financial institution reviews the request under a program that entails a comprehensive analysis to determine the creditworthiness of the request. The underwriting parameters of the analysis would be similar to those used by the institution to evaluate traditional mortgage applications. Most importantly, a preapproval request must be evidenced by an institution's issuance of a binding written commitment that grants a purchase money mortgage in a specified amount for a specified period subject to certain conditions. For purposes of Regulation C, preapprovals apply to requests for purchase money mortgages only.

Regulation C also provides that a covered preapproval may be subject only to a limited set of conditions. These conditions are:

  • Identification of a property.
  • Verification that the applicant's financial situation has not changed since the request was approved.
  • Other conditions unrelated to creditworthiness that are typically included in traditional loan commitments (such as satisfactory completion of a home inspection or proof of a termite inspection).

The Commentary provides additional guidance on these limited conditions.

Prequalifications
Regulation B. Generally, a prequalification request is a request by a prospective loan applicant for a preliminary determination on whether or not the applicant would qualify for credit under the creditor's standards.

As with preapprovals, prequalifications are discussed in the Commentary, rather than the regulation itself. Section 202.2(f)(3) of the Commentary discusses when an inquiry or prequalification becomes an application, while §202.9-5 discusses when a prequalification becomes a denied application and thereby requires an adverse action notice. Both sections to the Commentary clearly indicate that whether a prequalification becomes an application depends on how the creditor responds to the consumer's request or inquiry, and not on what the consumer asks or says.

A creditor may treat a prequalification request merely as an inquiry, and not an application, if certain conditions are met. Specifically, only an inquiry occurs if the creditor evaluates specific information about the consumer and tells the consumer the loan amount, rate, and other terms of credit the consumer would qualify for under various loan programs, but also explains to the consumer that he or she would still need to submit a mortgage application or preapproval request.

On the other hand, a prequalification request becomes a denied application for purposes of Regulation B when a creditor, after evaluating information provided by a consumer, decides that it would not approve the request, and communicates that decision orally or otherwise to the consumer. For example, if a consumer makes a prequalification request for a residential mortgage loan and informs the creditor of a previous bankruptcy and the creditor, in turn, informs the consumer that he or she would not qualify because of the bankruptcy, then the creditor has denied an application for credit. Further, §202.9-5 of the Commentary stipulates that, in such an instance, the consumer must be treated as a denied applicant and be provided with a written adverse action notice.

Section 202.9(a)(7) of the Commentary indicates that when adverse action is taken by telephone, the creditor must request the applicant's name and address in order to provide the written notification of adverse action. If the applicant refuses to provide that information, then the creditor has no further obligation to provide the notification. Thus, if a financial institution routinely fields prequalification requests by telephone and evaluates information offered by consumers during such requests that may result in denied mortgage applications, then the institution should have adequate procedures in place to provide written adverse actions to consumers who have been denied. Moreover, bankers should keep in mind that Regulation B's adverse action notification requirements apply even though a bank does not report denied prequalifications or other prequalifications on its HMDA LAR, consistent with the provisions of Regulation C.

Regulation C. Section 203.3(b) of the Commentary to Regulation C, rather than the regulation itself, defines a prequalification request as "a request by a prospective loan applicant for a preliminary determination on whether the prospective applicant would likely qualify for credit under an institution's standards, or for a determination on the amount of credit for which the prospective applicant would likely qualify." In contrast to a preapproval, a prequalification is not evidenced by the issuance of a binding written agreement.

Some institutions evaluate prequalification requests through a procedure that is separate from the institution's normal loan application process; others use the same process. In either case, Regulation C does not require an institution to report prequalification requests on its LAR, even though prequalification requests may constitute applications under Regulation B for purposes of the issuance of adverse action notices. For purposes of Regulation C, the Board has indicated that a preapproval request that has been approved without a written commitment would be treated as a prequalification.

Conclusion
To ensure ongoing compliance with Regulations B and C, management should be aware of each regulation's provisions regarding preapprovals and prequalifications and the responsibilities that such provisions place upon the institution. In addition, management should ensure that the institution's policies and procedures, including procedures for training staff, adequately comply with the regulations' requirements. In this regard, applicable policies and procedures should be updated as appropriate and compliance oversight, including audits and reviews, should be intensified during the initial stages of the procedures enhancement period to ensure that the new procedures and related training are effective.

If you have any questions regarding the definitions of "preapprovals" or "prequalifications," please contact Senior Examiner Carletta M. Longo or Robin P. Myers, Consumer Compliance/CRA Examinations Unit Manager through the Regulations Assistance Line at (215) 574-6568.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.