A naked, or “uncovered,” option is an option that is issued and sold without the seller setting aside enough shares or cash to meet the obligation of the option when it reaches expiration.
Investors can’t exercise an option without the underlying security, but they can still trade the option to make a profit, by selling the option for a premium.
When an option writer sells an option, they’re obligated to deliver the underlying securities (in the case of a call option) or cash (in the case of a put) to the option holder at expiration.
But because a naked writer doesn’t hold the securities or cash, they need to buy it or find it if the option they wrote is in the money, meaning that the investor exercises the option for a profit.
What is a Naked Option?
When an investor buys an option, they’re buying the right to buy or sell a security at a specific price either on or before the option contract’s expiration. An option to buy is known as a “call” option, while an option to sell is known as a “put” option.
Investors who buy options pay a premium for the privilege. To collect those premiums, there are investors who write options. Some hold the stock or the cash equivalent of the stock they have to deliver when the option expires. The ones who don’t are sometimes called naked writers, because their options have no cover.
Naked writers are willing to take that risk because the terms of the options factor in the expected volatility of the underlying security. This differs from options based on the price of the security at the time the option is written. As a result, the underlying security will have to not only move in the direction the holder anticipated, but do so past a certain point for the holder to make money on the option.
There are risks and rewards associated with naked options. It’s important to understand both sides.
Naked Writers Often Profit
The terms of naked options have given them a track record in which the naked writer tends to come out on top, walking away with the entire premium. That’s made writing these options a popular strategy.
Those premiums vary widely, depending on the risks that the writer takes. The more likely the broader market believes the option will expire “in the money” (with the shares of the underlying stock higher than the strike price), the higher the premium the writer can demand.
But Sometimes the Options Holder Wins
In cases where the naked writer has to provide stock to the option holder at a fixed price, the strategy of writing naked call options can be disastrous. That’s because there’s no limit to how high a stock can go between when a call option is written and when it expires.
While there are some large institutions whose business focuses on writing options, some qualified individual investors can also write options.
Because naked call writing comes with almost limitless risks, brokerage firms only allow high-net-worth investors with hefty account balances to do it. Some will also limit the practice to wealthy investors with a high degree of sophistication. To get a better sense of what a given brokerage allows in terms of writing options, these stipulations are usually detailed in the brokerage’s options agreement. The high risks of writing naked options are why many brokerages apply very high margin requirements for option-writing traders.
Generally, to sell a naked call option, for example, an investor would tell their broker to “sell to open” a call position. This means that the investor would write the naked call option. An investor would do this if they expected the stock to go down, or at least not go any higher than the volatility written into the option contract.
If the investor who writes a naked call is right, and the option stays “out of the money” (meaning the security’s price is below a call option’s strike price) then the investor will pocket a premium. But if they’re wrong, the losses can be profound.
This is why some investors, when they think a stock is likely to drop, are more likely to purchase a put option, and pay the premium. In that case, the worst-case scenario is that they lose the amount of the premium and no more.
How to Manage Naked Option Risk
Because writing naked options comes with potentially unlimited risk, most investors who employ the strategy will also use risk-control strategies. Perhaps the simplest way to hedge the risk of writing the option is to either buy the underlying security, or to buy an offsetting option. The other risk-mitigation strategies can involve derivative instruments and computer models, and may be too time consuming for most investors.
Another important way that options writers try to manage their risk is by being conservative in setting the strike prices of the options. Consider the sellers of fifty-cent put options when the underlying stock was trading in the $100 range. By setting the strike prices so far from where the current market was trading, they limited their risk. That’s because the market would have to do something quite dramatic for those options to be in the money at expiration.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
The Takeaway
With naked options, the investor does not hold a position in the underlying asset. Because this is a risky move, brokerage firms may allow their high-net-worth investors to write naked options.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
With SoFi, user-friendly options trading is finally here.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes. Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Simple interest is the money earned after investing or depositing a principal amount, and compound interest refers to the interest accrued on that principal amount and the interest already earned. While interest is typically earned or accrued in a savings account, it can play a role in an investing portfolio, as certain types of investments (CDs, bonds) may involve interest payments, adding to overall investing returns. Note, though, that interest is different from investment returns.
Further, Albert Einstein is reputed to have said that compound interest is the eighth wonder of the world. It’s easy to see why. Continuous growth from an ever-growing base is the fundamental reason investing is so compelling a practice. Compounding has the potential to grow the value of an asset more quickly than simple interest. It can rapidly increase the amount of money you owe on some loans, since your interest grows on top of both your unpaid principal as well as previous interest charges.
What Is Simple Interest?
In basic terms, simple interest is the amount of money you are able to earn after you have initially invested a certain amount of money, referred to as the principal. Simple interest works by adding a percentage of the principal — the interest — to the principal, which increases the amount of your initial investment over time.
When you put money into an average savings account, chances are you are accruing a small amount of simple interest.
APY is the annual rate of return that accounts for compounding interest. APY assumes that the funds will be in the investment cycle for a year, hence the name “annual yield.” If your interest rate is low, you might be missing out on cash that could otherwise be in your pocket. And it may be worthwhile to look into other types of accounts that could earn you more interest.
💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.
Simple Interest Formula
Calculating interest is important for figuring out how much a loan will cost. Interest determines how much you have to pay back beyond the amount of money you borrowed.
The simple interest formula is I = Prt, where I = interest to be paid, r is the interest rate, and t is the time in years.
So if you’re taking out a $200 loan at a 10% rate over one year, then the interest due would be 200 x .1 x 1 = $20.
But let’s say you want to know the whole amount due, as that’s what you’re concerned about when taking out a loan. Then you would use a different version of the formula:
P + I = P(1 + rt)
Here, P + I is the principal of the loan and the interest, which is the total amount needed to pay back. So to figure that out you would calculate 200 x (1 + .1 x 1), which is 200 x (1 + .1), or 200 x 1.1, which equals $220.
Example of Simple Interest
For example, let’s say you were to put $1,000 into a savings account that earned an interest rate of 1%. At the end of a year, without adding or taking out any additional money, your savings would grow to $1,010.00.
In other words, multiplying the principal by the interest rate gives you a simple interest payment of $10. If you had a longer time frame, say five years, then you’d have $1,050.00.
Though these interest yields are nothing to scoff at, simple interest rates are often not the best way to grow wealth. Since simple interest is paid out as it is earned and isn’t integrated into your account’s interest-earning balance, it’s difficult to make headway. So each year you will continue to be paid interest, but only on your principal — not on the new amount after interest has been added.
What Is Compound Interest?
Most real-life examples of growth over time, especially in investing and saving, are more complex. In those cases, interest may be applied to the principal multiple times in a given year, and you might have the loan or investment for a number of years.
In this case, compound interest, means the amount of interest you gain is based on the principal plus all the interest that has accrued. This makes the math more complicated, but in that case the formula would be:
A = P x (1 + r/n)^(nt)
Where A is the final amount, P is the principal or starting amount, r is the interest rate, t is the number of time periods, and n is how many times compounding occurs in that time period.
Example of Compound Interest
So let’s take our original $200 loan at 10% interest but have it compound quarterly, or four times a year.
So we have:
200 x (1 + .1 / 4)^(4×1)
200 x (1 + .025)^4
200 x (1.025)^4
200 x 1.10381289062
The final amount is $220.76, which is modestly above the $220 we got using simple interest. But surely if we compounded more frequently we would get much more, right?
More Examples of Compound Interest
Let’s look at two other examples: compounding 12 times a year and 265 times a year.
For monthly interest we would start at:
200 x (1 + .1/12)^(12×1)
200 x (1 + 0.0083)^12
200 x 1.00833^12
200 x 1.10471306744
220.94
If we were to compound monthly, or 12 times in the one year, the final amount would be $220.94, which is greater than the $220 that came from simple interest and the $220.76 that came from the compound interest every quarter. And both figures are pretty close to $221.03.
Notice how we get the biggest proportional jump from one of these interest compoundings to another when we go from simple interest to quarterly interest, compared to less than 20 cents when we triple the rate of interest to monthly.
But we only get 18 cents more by compounding monthly instead of quarterly, and then only 9 cents more by going from monthly to as many compoundings as theoretically possible.
What Is Continuous Compounding?
Continuous compounding calculates interest assuming compounding over an infinite number of periods — which is not possible, but the continuous compounding formula can tell you how much an amount can grow over time at a fixed rate of growth.
Continuous Compounding Formula
Here is the continuous compounding formula:
A = P x e^rt
A is the final amount of money that combines the initial amount and the interest
P = principal, or the initial amount of money
e = the mathematical constant e, equal for the purposes of the formula to 2.71828
r = the rate of interest (if it’s 10%, r = .1; if it’s 25%, r = .25, and so on)
t = the number of years the compounding happens for, so either the term or length of the loan or the amount of time money is saved, with interest.
Example of Continuous Compounding
Let’s work with $200, gaining 10% interest over one year, and figure out how much money you would have at the end of that period.
Using the continuously compounding formula we get:
A = 200 x 2.71828^(.1 x 1)
A = 200 x 2.71828^(.1)
A = 200 x 1.10517084374
A = $221.03
In this hypothetical case, the interest accrued is $21.03, which is slightly more than 10% of $200, and shows how, over relatively short periods of time, continuously compounded interest does not lead to much greater gains than frequent, or even simple, interest.
To get the real gains, investments or savings must be held for substantially longer, like years. The rate matters as well. Higher rates substantially affect the amount of interest accrued as well as how frequently it’s compounded.
While this math is useful to do a few times to understand how continuous compounding works, it’s not always necessary. There are a variety of calculators online.
The Limits of Compound Interest
The reason simply jacking up the number of periods can’t result in substantially greater gains comes from the formula itself. Let’s go back to A = P x (1 + r/n)^(nt)
The frequency of compounding shows up twice. It is both the figure that the interest rate is divided by and the figure, combined with the time, that the factor that we multiply the starting amount is raised to.
So while making the exponent of a given number larger will make the resulting figure larger, at the same time the frequency of compounding will also make the number being raised to that greater power smaller.
What the continuous compounding formula shows you is the ultimate limit of compounding at a given rate of growth or interest rate. And compounding more and more frequently gets you fewer and fewer gains above simple interest. Ultimately a variety of factors besides frequency of compounding make a big difference in how much savings can grow.
The rate of growth or interest makes a big difference. Using our original compounding example, 15% interest compounded continuously would get you to $232.37, which is 16.19% greater than $200, compared to the just over 10% greater than $200 that continuous compounding at 10% gets you. Even if you had merely simple interest, 15% growth of $200 gets you to $230 in a year.
Interest and Investments
As noted previously, interest can play a role in an investment portfolio, but it’s important to note the distinction between investing returns and interest – they’re not the same. However, if an investor’s portfolio contains holdings in investment vehicles or assets such as certificates of deposit (CDs) or certain bonds, there may be interest payments in the mix, which can and likely will have an impact on overall investing returns.
It can be important to understand the distinction between returns and interest, but also know that there may be a relationship between the two within an investor’s portfolio.
💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.
The Takeaway
Simple interest is the money earned on a principal amount, and compound interest is interest earned on interest and the principal. Understanding the ways in which interest rates can work both for and against you is an important step in helping to secure your future financial stability. Interest is typically earned in a bank account, but it can also play a role in an investment portfolio, to some degree.
Interest is typically earned in a bank account, but it can also play a role in an investment portfolio, to some degree.
If you’re interested in investing and making your money work harder for you, then identifying interest types and finding ways to earn as much interest as possible could be the difference in thousands of dollars over the course of your life. The bottom line, though, is that the longer you invest, the more time you have to weather the ups and downs of the stock market, and the more time your earnings have to compound.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Probability of Member receiving $1,000 is a probability of 0.028%.
Investing in individual bonds can be complicated, but exchange-traded funds (ETFs) that invest in bonds — a.k.a. bond ETFs — can provide a more straightforward way to invest in fixed income securities.
Investors may associate ETFs with stocks, thanks to the popular ETFs that track stock indices like the S&P 500. ETFs also happen to trade on stock exchanges, like the New York Stock Exchange.
Bond ETFs work similarly. Though the ETF holds bonds and not stocks, it trades on a stock exchange. Said another way, a bond ETF is a bundle of bonds that an investor can trade like a stock.
Bond ETFs make it possible for investors to buy a diversified set of bonds, without the time and effort it would take to build a portfolio of individual bonds.
Before getting into the specifics of bond ETFs, it will be helpful to understand ETFs and bonds separately. Let’s begin with ETFs.
ETF 101: Reviewing the Basics
An investment fund provides a way to pool money with other investors so that money can then be spread across many different investments (sometimes referred to as a “basket” of investments).
For most small investors, it would be too costly to individually purchase 500 individual stocks or 1,000 individual bonds. But such a thing becomes possible when doing it alongside thousands of other investors. Though different vehicles, mutual funds and ETFs provide investors with an incredible opportunity to diversify their investments.
For retail investors, investment funds come in two major varieties: mutual funds and exchange-traded funds. Mutual funds and ETFs are constructed differently — ETFs were built to trade on an exchange, as the name implies — but both can be useful tools in gaining broad diversification.
Whether investors will choose a mutual fund or ETF will likely depend on their preference, and context. For example, someone using a workplace retirement plan may only have access to mutual funds, so that’s what they use.
Someone who is investing independently may choose ETFs, because it’s possible to purchase them without any of the normally associated trading costs.
Whether an investor is using a mutual fund or an ETF, what’s most important is what’s held inside that fund. Think of an ETF as a basket that holds an array of securities, like stocks or bonds.
Most ETFs will hold just one type of security — only stocks or only bonds, for example. A bond ETF could be broad, or it could contain a narrower sliver of the bond market, like corporate bonds, green bonds, or short-term treasury bonds.
💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.
What Is a Bond?
Effectively, a bond is a loan to an organization: i.e. a company, government, or other entity. Investors loan the entity their money, and then the entity pays interest on the amount of that loan.
There are countless types of bonds. Treasuries are loans to the U.S. government. Municipal bonds are loans to a state or local government. Companies sometimes issue bonds in order to raise money. These entities are borrowing money from investors and issuing IOUs in the form of bonds.
How Bonds Work
When investors buy a bond, they are agreeing to the rate of interest and other terms set by the bond. Because bonds pay a fixed rate of interest, bonds are sometimes referred to as fixed-income investments.
Bonds typically make interest payments, sometimes referred to as coupon payments, twice annually.
Example of a Bond
Let’s say an investor buys a Coca-Cola bond for $10,000 that pays a 4% rate of interest over 20 years. The bond earns $400 every year, earning the investor a total of $8,000 over the 20-year period. At the end of the period, the $10,000 “principal” investment is returned. As long as the investor holds the bond for the full 20 years, there should be no surprises.
Because bonds pay a fixed rate of return, their earnings potential is largely predictable. But there is limited upside on what can be earned on a bond. For this reason, bonds are considered to be a safer, less volatile complement to stock holdings, which have a higher potential for returns over time.
Types of Bonds
Bonds are issued by different entities and are often categorized by the issuer. There are four categories of bonds available to investors.
Treasury bonds: Bonds issued by the U.S. government.
Municipal bonds: Bonds issued by local governments or government agencies.
Corporate bonds: Bonds issued by a public corporation.
Mortgage and asset-backed bonds: Bonds that pass through the interest paid on a bundle of debts, such as a bundle of mortgages, student loans, car loans, or other financial assets.
As one could imagine, there are many subtypes within these broad categories.
When it comes to risk, the bond market produces a wide range. Corporate, municipal, and asset-backed bonds are generally considered to be higher risk than treasury bonds.
Whereas a business or even a municipal government could potentially “default” on a loan, it is highly unlikely that the U.S. government would go bankrupt. (As yet, the U.S. government has never defaulted on a treasury bond.)
Because they are considered low risk, U.S. treasury bonds typically pay less interest than the other bond types. This is an important trade-off to understand. Higher-risk investments should pay a higher rate of interest in order to compensate the investor for taking on that additional risk.
This is why it is possible to see bonds with high rates of interest issued by unstable governments or by highly speculative companies. These are often referred to simply as high-yield bonds or junk bonds.
Bonds can also vary by their maturity dates. It is possible to purchase bonds with a wide range of timelines, ranging from the very short (a few days) to the very long (30 years). Although it depends on the current state of interest rates, long-term bonds tend to pay more than short-term bonds. This should make intuitive sense; investors want to be compensated for locking their money up for longer periods.
Benefits of Bond ETFs
While bonds offer certain benefits to investors, including relatively low risk and predictable income, these instruments are complex. Owning and managing a portfolio of bonds requires experience and sophistication. This is where bond ETFs come in. In some ways, bond ETFs give retail investors easier access to the bond market.
Bond ETFs can be purchased in small dollar amounts.
For some bonds, the starting price is $1,000. This can be prohibitive for small investors who don’t have $1,000 to start building their bond portfolio, let alone a diversified one.
Generally, ETFs are sold by the share, and the cost of one share varies by ETF. Some trading platforms allow for the purchase of partial shares, which allows investors to get started with as little as $1.
They provide diversification.
It is possible to buy into a fund of hundreds or thousands of bonds using a bond ETF. This type of portfolio diversification would be otherwise impossible to achieve for small investors trying to build a bond portfolio on their own. ETFs make diversification a possibility, even at very small dollar amounts.
They are low cost.
ETFs, by their nature, are low cost. Because they are typically passive funds by style, the management fee embedded within the fund — called the expense ratio — is typically quite low. Compare this to an actively managed mutual fund of bonds, where the expense ratios can top 1%.
There’s another fee that investors will want to be aware of, called a trading cost or transaction fee. This is the cost of buying and selling ETFs (and stocks). These fees can be quite prohibitive for smaller investors. Luckily, there are ways to buy ETFs without paying any trading or transaction fees.
They are easy to buy and sell.
Individual bonds are not always easy to buy and sell. Said another way, they are not particularly liquid. Bonds do not trade on an open exchange, like stocks and ETFs. It is likely that an investor would need to involve a professional to broker the transaction.
ETFs, on the other hand, are very easy to sell. Most banks and trading platforms allow investors to do it themselves, online. This way, an investment can be sold quickly if needed.
💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.
Downsides of Bond ETFs
Bond ETFs do have their downsides, though.
Bond ETFs reveal underlying price changes in the bonds, which some investors may find disconcerting. Because yes, it is possible for bonds, and a bond ETF, to lose value.
When holding an individual bond or a portfolio of bonds, an investor is not provided minute-by-minute updates of the market value of that investment. In this way, a bond is like a house. There is no ticker sitting above anyone’s house that tells them the value of that property at that very second.
This is not the case with a bond ETF, where price changes can be felt in near real time. It will be important that investors are prepared for this. It is generally not wise to make a decision about long-term investments based on recent price gyrations, not just with stocks but with bonds, too.
The Takeaway
The first step is to research bond ETFs, as there are many kinds. Bond ETFs can be broad and cover a wide sample of the bond market, or they can be narrower. For example, it is possible to buy a long-term treasury bond ETF or a bond ETF that only holds certain municipal bonds.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, LLC and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below. Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer to sell, solicitation to buy or a pre-qualification of any loan product offered by SoFi Lending Corp and/or its affiliates.
Advisory services are offered through SoFi Wealth LLC, an SEC-registered investment adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at adviserinfo.sec.gov .
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Getting mortgage preapproval can give you an edge in the home-buying process, especially when the housing market is tight. A mortgage preapproval from a lender lets sellers know that you have tentatively been approved for a specific loan type and amount. Not only does this show that you’re a serious home shopper, it also helps give you a good sense of your budget as you go house-hunting.
Here, you’ll learn the ins and outs of how to get preapproved for a home loan, including:
• What is mortgage preapproval?
• How do mortgage preapproval and prequalification compare?
• What are the pros and cons of mortgage preapproval?
• How can you improve your chances of getting preapproved for a mortgage loan?
• What can you do if you aren’t preapproved for a mortgage?
• Mortgage pre-approval is an important step in the homebuying process that helps determine how much you can afford.
• Pre-approval involves submitting financial documents and undergoing a credit check to assess your eligibility for a mortgage.
• It’s recommended to get pre-approved before house hunting to have a clear budget and show sellers you’re a serious buyer.
• Pre-approval letters typically have an expiration date and may require updating if your financial situation changes.
• Keep in mind that pre-approval is not a guarantee of a loan, and final approval will depend on additional factors.
What Is Mortgage Preapproval?
Mortgage preapproval involves a thorough review of your credit and financial history. If you look like a good candidate for a mortgage, a lender will issue a letter stating that you qualify for a loan of a certain loan amount and at a certain interest rate. The letter is an offer, but not a commitment, to lend you a specific amount. It’s good for up to 90 days, depending on the lender.
You’ll want to shop for homes within the price range of your preapproved mortgage. Armed with your preapproval for a home loan, you can show sellers that you are a serious buyer with the means to purchase a property. In the eyes of the seller, preapproval can often push you ahead of other potential buyers who have not yet been approved for a mortgage and make it easier to compete when there are multiple offers on a house.
Once you find a house that you want to buy, you can make an offer immediately based on the loan amount for which you are preapproved. And if the seller accepts, it will be time to finalize your mortgage application. At this point, a loan underwriter will review your application and conduct other due diligence measures, such as having the house appraised to make sure it is valued at the price it’s selling for. If all goes well, the lender will issue another letter called a commitment letter, which officially seals the deal on your loan, and you can schedule a closing date.
When Should I Get Preapproved for a Home Loan?
Preapproval typically lasts for 90 days, at most, so you want to seek it when you are actively in the market for a new home. Maybe you’ve done some initial online research into available properties. Hopefully, you’ve also had a good look at your finances and thought about how much you have available to spend on a down payment as well as what amount of monthly mortgage payments you can afford long-term. It takes around 10 days after you submit a request to be preapproved, so factor that timing into your house search as well.
Mortgage Preapproval vs. Prequalification
If you are house hunting, you will likely hear two different terms regarding early mortgage moves: prequalification vs. preapproval. Prequalification is a simple, less involved view of your financial qualifications for a mortgage. Preapproval for a home loan is a more in-depth review of your finances and an indicator that your loan application will likely move forward smoothly. Each has its advantages, and its moment.
Mortgage Prequalification
Getting prequalified for a home loan involves a review of a few financial details — usually self-reported — such as income, assets, and debt. The lender will then estimate how much of a mortgage you can afford.
Pros of Mortgage Prequalification
• It’s fast. The process can often be done in minutes, by phone or online.
• You’ll zero in on house prices. Prequalifying for a home loan quickly gives you an idea of what your monthly payment might be and how much house you can afford.
• You can shop around. You can prequalify with multiple lenders to see what types of terms and interest rates they offer.
• It’s easy on your credit score. Prequalification will not affect your credit score because it only requires a “soft inquiry” into your credit record.
Cons of Mortgage Prequalification
• It’s no guarantee. Because it is an unverified, high-level look at your finances, prequalification doesn’t ensure that you will actually qualify for a mortgage.
• It won’t help you bargain. Being prequalified won’t help you negotiate a lower price with a seller or compete against other bidders in a competitive market.
Mortgage Preapproval
Requesting a mortgage preapproval is a more complicated process than getting prequalified. You’ll have to fill out an application with your chosen lender and agree to a credit check. The credit check will be a “hard pull” which will ding your credit score by a few points. You’ll also provide information about your income and assets. The evaluation process can take 10 days or more. Again, preapproval doesn’t mean it’s a done deal that you’ll get the loan, but it is a solid indication of your financial situation and ability to purchase a home.
There are a number of advantages to getting preapproval for a home loan, especially if you’re shopping in a fast-moving market.
Pros of Mortgage Preapproval:
• It gives you an edge. Sellers will see that you are a serious buyer and have assurance that your financing won’t fall through and sink the deal.
• It helps you get loan shopping done. When you’ve found your dream house, you don’t want to delay putting in an offer because you have to spend time getting your documents together and pursuing a loan. Going through the preapproval process helps you take care of these details before you’re in a fast-moving market.
Cons of Mortgage Preapproval:
• A mortgage preapproval expires. How long does a mortgage preapproval last? As noted above, the letter is only good for a certain period of time, usually 90 days, so you’ll want to make sure you’re seriously ready to start shopping once you have your mortgage preapproval in hand.
• The application is time-consuming. You’ll need to provide a lot of documentation to get a mortgage preapproval and agree to a hard credit inquiry, which can drag down your credit score, though usually only by a bit.
• Nothing is guaranteed. Even though your home loan preapproval letter likely has details on your loan amount and type, it is only tentative approval — you still can’t be 100% sure that you will get the loan.
Here are the basic comparison points of prequalification vs. preapproval:
The Difference Between Prequalification and Preapproval
Prequalification
Preapproval
Process
• Simple process that takes only a few minutes online or by phone.
• You’ll fill out a thorough application and provide documents. The process can take 10 days or more.
Required materials
• High-level financial details you provide; sometimes a “soft” credit check which won’t impact your rating.
• Full application and supporting financial documents, as well as a “hard pull” credit check that will ding your rating.
Benefits
• Can give you an idea of what you can afford as you start the process.
• Lets you compare lenders and rates.
• Tentatively approves you for a loan amount and type.
• Can provide leverage when you’re ready to get serious about buying.
Drawbacks
• Won’t give you an advantage in negotiations or a bidding war.
• It’s no guarantee you’ll get a mortgage.
• Preapproval is good for 90 days so your home-finding timeline may be affected.
• Does not guarantee you’ll get the loan.
First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.
Steps to Get Preapproved for a Home Loan
Getting preapproved for a home loan will take some time, so it’s good to get the process started before you are ready to make an offer on a home. Here are some important steps along the way.
Check Your Credit Score
If you’ve established a credit history, a first step before applying for a mortgage is to check your credit reports, which are a history of your credit compiled from sources like banks, credit card companies, collection agencies, and the government.
The information is collected by the three main credit reporting bureaus: TransUnion®, Equifax®, and Experian®. You’ll want to make sure that the information on your credit reports is correct. Ordering the reports is free once a year through AnnualCreditReport.com .
If you find any mistakes in your credit report, contact the credit reporting agencies immediately to let them know. You don’t want any incorrect information weighing down your credit score, putting your chances for preapproval at risk.
The free credit reports provided by the nationwide credit reporting agencies do not include your credit score, a number typically between 300 and 850. You can purchase your score directly from the credit reporting agencies, or from FICO®. Your credit card company also may provide your credit score for free, or you could try a money tracker app that updates your credit score weekly and tracks your spending at no cost.
Calculate Your Potential Mortgage
To help with the prequalification and preapproval process, use the mortgage calculator below to see what your estimated monthly mortgage would be based on down payment, interest rate, and loan terms.
Gather Documentation
Your credit score is only one of many factors a potential lender will consider when deciding on your mortgage qualification. So collect the many other documents you will need to paint a full picture of your financial life. Ask the lender what is needed, specifically. The list will likely include:
• Recent pay stubs
• Recent bank and investment account statements
• Two years of tax returns and/or W2s, possibly more if you are self-employed
• Verification of alimony or child support payments received and the court documents spelling out the terms of the payments
• Social Security award letter, if you derive income from Social Security
• Gift letter documenting any money you are receiving from family or other sources toward a down payment
Receive Your Mortgage Preapproval Letter
Your first instinct when you receive preapproval will likely be to jump for joy. Next, take a moment to ask the lender if they made any assumptions about your finances in order to issue the letter, or if they flagged anything that could lead to you being denied a mortgage later on, or that could increase your costs. Doing this could help you head off future problems that might scuttle a deal.
Upping Your Odds of Mortgage Preapproval
There are a number of steps you can take to increase your chances of preapproval or to increase the amount your lender may approve you for.
Build Your Credit
When you apply for any type of loan, lenders want to see that you have a history of properly managing your debt before offering you credit themselves.
You can build your credit history by opening and using a credit card and paying your bills on time. Or you could consider having regular payments, such as your rent, tracked and added to your credit score.
Your ability to pay your bills on time has a big impact on your credit score. If your budget allows, you should aim to make payments in full.
If you have any debts that are dragging down your credit score — for example, debts that are in collection — it’s smart to work on paying them off first, as this could help build your score.
“Really look at your budget and work your way backwards,” explains Brian Walsh, CFP® at SoFi, on planning for a home mortgage.
Your debt-to-income ratio is your monthly debt payments divided by your monthly gross income. If you have $1,000 a month in debt payments and make $5,000 a month, your debt-to-income (DTI) ratio is $1,000 divided by $5,000, or 20%.
Mortgage lenders typically like to see a DTI ratio of 36% or less. Some may qualify borrowers with a higher DTI, up to 43%. Lenders may assume that borrowers with a high DTI ratio will have a harder time making their mortgage payments.
If you’re seeking preapproval for a mortgage, it may be beneficial to keep the ratio in check by avoiding large purchases. For example, you may want to hold off on buying a new car until you’ve been preapproved.
Prove Consistent Income
Your lender will want to know that you have enough money coming in each month to cover a potential mortgage payment, so the lender will likely want proof of consistent income for at least two years (that means pay stubs, W-2s, etc.).
For some potential borrowers, such as freelancers, this may be a tricky process since they may have income from various sources. Keep all pay stubs, tax returns, and other proof of income, and be prepared to show those to your lender.
What Happens If Your Mortgage Preapproval is Rejected?
Rejection hurts. But if you aren’t preapproved or you aren’t approved for a large enough mortgage to buy the house you want, you also aren’t powerless. You can ask the lender why it said “no.” This will give you an idea about what you might need to work on in order to secure the mortgage you want.
Then you may want to work on the factors that your lender saw as a sticking point to preapproval. You can continue to work to build your credit score, lower your DTI ratio, or save for a higher down payment.
If you’re able to pay more upfront, you will typically lower your monthly mortgage payments. Once you’ve worked to make yourself a better candidate for a mortgage, you can apply for preapproval again.
Dream Home Quiz
The Takeaway
In a competitive market, having a mortgage preapproval letter in hand may give a house hunter an edge. After all, the letter states that the would-be buyer tentatively qualifies for a home loan of a certain amount.
Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.
SoFi Mortgages: simple, smart, and so affordable.
FAQ
What happens during the preapproval process?
During the mortgage preapproval process you’ll provide lots of background information on your finances. A potential lender will also check your credit score. If the lender feels you’re a suitable candidate for a loan, you’ll receive a letter that you can show a seller to better your chances when making an offer on a home.
Do preapprovals hurt your credit score?
The lender will do a “hard pull” to obtain your credit score prior to a preapproval. This may cause your rating to drop by a few points, but it should rebound quickly if you pay your bills on time.
How far in advance should I get preapproved for a mortgage?
Get preapproved for a mortgage when you have a sense of the housing costs where you are shopping for a home, and you are ready to start looking in earnest.
Which is better preapproval or prequalification?
Prequalification and preapproval each have a place in the homebuying process. Prequalification is helpful when you are trying to get a sense of what you can afford and which lender might offer the best terms. It’s time for preapproval when you are serious about searching for a home and have researched possible lenders.
Is it OK to get multiple preapprovals?
You only need one preapproval, but it is fine to get a few if you want to see what loan amounts and rates you might qualify for. Make all applications within a 45-day window — the time frame during which multiple lenders can check your credit without each check having an additional impact on your score.
*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
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Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility for more information.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .
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Whether you’re chasing down a dream or looking at an irresistible piece of land in a town far away, you might find yourself wondering how to move to another state.
Will it be difficult? How much will it cost? What will the expenses entail? There’s a lot to consider when relocating — here are some things to keep in mind.
Is It Hard to Move to Another State?
Generally speaking, moving to a new state may take some work, and planning for it might need to happen well in advance to ensure everything stays on track.
You’ll want to consider things like potential neighborhoods to live in, crime rates, the school system, transportation options, and walkability. Before you move, you may also want to think about what items you’ll want to take with you (and what you’ll need to donate), what your moving budget is, and whether it makes sense to hire professional movers.
A Simple Checklist For Moving Out of State
Sometimes, a good old-fashioned moving checklist is the easiest way to ensure things get done on time:
1. ⃞ Find a place to live.
2. ⃞ Select a moving date. If your schedule is flexible and costs are a concern, consider moving during a weekday, which tends to be cheaper than the weekend.
3. ⃞ Select a professional mover (if using one). Request a few quotes from reputable movers.
4. ⃞ Build a budget based on common moving expenses plus any other cost considerations unique to your move.
5. ⃞ Take stock of and sort your stuff about one month before the move. What needs to come along? What should be tossed? What can be given to charity? Start sorting, selling, packing, trashing, and donating accordingly.
6. ⃞ Cancel old services/start new ones. Schedule the stoppage of utilities like cable, internet, gas, and electric, and set up installations at your new location. It could also be a good time to update or cancel gym memberships, delivery services, subscriptions, etc.
7. ⃞ Gather up boxes and packing supplies. About three weeks before the move, start securing boxes, rolls of packing tape, bubble wrap, and other supplies.
8. ⃞ Pack it all up. You might wait until moving day to get the toothpaste into the “personal items” box, but the two weeks before the move can be spent packing belongings and gathering important documents like leases, moving contracts, and moving expense receipts.
9. ⃞ Say farewell. It might sound cheesy, but giving a thoughtful goodbye to any home that held you can be helpful for moving ahead. Perhaps the last pie from your favorite local pizzeria is in order.
How Much Money Should You Save to Move Out of State?
When planning how to move to another state, knowing how much to save to cover moving expenses is an important initial step.
The average cross-country move typically costs somewhere between $2,648 and $6,979, according to HomeAdvisor, with the average amount being around $4,800.
Several other factors can influence how much someone should save to move out of state, such as the number of items they’re moving, how far they’re going, and whether they plan to move themselves or hire professionals. In some cases, long distance moving costs could reach $10,000 or more.
Common Moving Expenses
To decide how much money to save for a move out of state, knowing the most common moving expenses can be helpful:
• A deposit on the new place, which is typically first and last month’s rent/security on an apartment, or a down payment on a new house.
• Moving costs, or the amount of money it takes to physically move items — whether with rented equipment or professional movers — from point A to point B. As previously mentioned, they average $4,800 for an out-of-state move, but this figure can vary depending on the distance of the move and the company hired.
• Transportation costs for traveling to the final destination. A fuel cost calculator can be a helpful tool to get an idea of how much to budget for this expense.
• Packing supplies like boxes, packaging tape, bubble wrap, packing peanuts, markers, etc.
• Cleaning supplies can get overlooked, but several surfaces might need scouring. From trash bags to all-purpose cleaners, carpet cleaning for pesky pet stains, mops, and more, having some funds saved for a clean slate can prove helpful in the moving process.
• Repair and maintenance costs might arise from issues like holes in the walls from hanging artwork, a broken light fixture, a torn screen, etc. Taking out a home improvement loan ensures things can be up to snuff in both abodes.
It can take a lot of time and energy to move to a different state. Luckily, there are several ways to save money in the process:
• Using cash for moving expenses instead of racking up credit card debt can save money over time.
• Selling unwanted items is a great way to create space, remove clutter, and acquire some extra moving funds.
• Packing with free supplies like used boxes or bubble wrap from friends, family or even the town “free stuff” page can help save lots versus buying brand new.
• Getting help from friends can help you save time which, in turn, can save you money. They can help with sorting, packing, cleaning, and even selling old items to their network.
• Asking an employer to help with relocation costs can potentially be negotiated, especially if you’re sticking with them in the new state.
• Relocation loans can be a solid saving option when you need quick cash to move to another state. They can cover a wide range of moving costs, from deposits to storage to professional movers, transportation, and even hotel stays.
The Takeaway
Moving out of state often requires detailed planning, preparation, and lots of considerations — like what it’s like to live in the new location, opportunities for employment, how to sort and pack belongings, how much to save in advance, whether to hire professional movers, what the moving budget is, and how to secure funds for moving costs. The good news is, there are ways to save for a move to another state. Ideas include using cash instead of credit, selling unwanted items, packing with free supplies, asking an employer for relocation assistance, and asking for packing and moving help from friends.
When it comes to paying for moving-related expenses, consider a SoFi personal loan. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
SoFi’s Personal Loan was named NerdWallet’s 2023 winner for Best Online Personal Loan overall.
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SoFi’s Personal Loan was named NerdWallet’s 2023 winner for Best Online Personal Loan overall.
SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
