Mortgage underwriting in the United States
Encyclopedia
Mortgage underwriting in the United States
is the process a lender uses to determine if the risk
of offering a mortgage loan
to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit
, capacity and collateral
.
To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage
and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.
is what the underwriter uses to review how well a borrower manages his or her current and prior debts. Usually documented by a credit report from each of the three credit bureaus, Equifax
, Transunion
and Experian
, the credit report provides information such as credit scores, the borrower’s current and past information about credit cards, loans, collections, repossession
and foreclosures and public records (tax liens, judgments and bankruptcies). Typically, a borrower’s credit is highly related to the probability that the loan will go into default (failure to make monthly installments).
In reviewing a credit report, the credit score
is considered. The credit score is an indicator of how well a borrower manages debt. Using a mathematical model
, the data regarding each item on the credit report is used to produce a number between 350 and 850, known as the credit score. Higher scores represent those with less risk
. When lenders refer to a representative credit score, they are referring to the median score. When multiple borrowers are involved typically the borrower with lowest median score is the one that is considered as the representative credit score. Other loan programs may consider the person that earns the most money, also known as the primary wage earner, that has the representative credit score. On many loan programs there are minimum score guidelines.
The most influential aspect of the credit report is quality of the credit on a person’s current housing. For an example, if the borrower already has a mortgage
, whether or not the borrower has paid that mortgage on time is indicative of how well they will pay in the future. This also holds true with people that rent. A lender will typically analyze the most recent 12–24 months of the borrower’s housing history. Delinquencies during that time period are usually unacceptable.
In addition, the history of payment of loans and revolving credit
is considered. A lender may require that a certain number of deposit accounts be opened for at least 24 months and have recent activity with on time payments to build a pattern of responsible use of credit.
The credit report also contains the borrowers past derogatory credit. This include collections, charge offs, repossession
, foreclosures, bankruptcies, liens and judgments. Typically, if any of these items are present on the report, it increases the risk of the loan. For more serious blemishes such as foreclosures and bankruptcies, a lender may require up to two to seven years from the date of satisfaction indicated by the report before approving a loan. Furthermore, the lender may require the borrower to reestablish the credit by obtaining a certain amount of new credit to rebuild their credit. It is also the prerogative of the lender to require that all collections, charge offs, liens and judgments be paid prior to closing the loan.
, income
, their current debt
and their assets.
While reviewing the borrower’s employment, the underwriter must determine the stability of the income. People who are employed by a company and earn hourly wages pose the lowest risk. Self-employed borrowers pose the highest risk, since they are typically responsible for the debt and well-being of the business in addition to their personal responsibilities. Commission income also carries similar risks in the stability of income because if for any reason the borrower fails to produce business, it directly influences the amount of income produced. Usually if self-employment or commission income is used to qualify for the mortgage, a two year history of receiving that income is required.
Documentation of the income also varies depending on the type of income. Hourly wage earners who have the lowest risks usually need to supply paystubs and W-2 statements. However, self-employed, commissioned and people who collect rent are required to provide tax returns. Retired people are required to evidence that they eligible for social security
and document the receipt of payments, while people that receive income via cash investments must provide statements and determine the continuance of the income from those payments. In short, the underwriter must determine and document that the income and employment is stable enough to pay the mortgage in years to come.
Furthermore, underwriters evaluate the capacity to pay the loan using a comparative method known as the debt to income ratio. This is calculated by adding up all of the monthly liabilities and obligations (mortgage
payments, monthly credit and loan payments, child support
, alimony
, etc.) and dividing it by the monthly income. For an example, if a borrower has a $500 car payment, $100 in credit and loan payments, pays $500 in child support and wants a mortgage with payments $1,000 per month, his total monthly obligations is $2100. If he makes $5,000 a month, his debt to income ratio is 42%. Typically the ratio must be below anywhere from 32% for the most conservative loans to 65% for the most aggressive loans.
Assets are also considered when evaluating capacity. Borrowers who have an abundance of liquid assets at the time of closing statistically have lower rates of default
on their mortgage. This is termed as reserves by the industry. For example, if your total mortgage payment is $1000 a month and you have $3000 left after you pay your down-payment and closing costs, you have 3 months reserves. Underwriter also looked closely at your bank statements for incidences of NSF's (non- sufficient funds). If this happens regularly, this is a red flag with the underwriter because this indicates that the borrower don't know how to manage their finances.
Furthermore, if the borrower’s employment is interrupted for any reason, the borrowers would have enough cash in reserve to pay their mortgage. The amount of cash reserves is qualified by the number of payments the borrower can make on their total housing expenditure (the total of the principal and interest payment, taxes, insurance
, homeowners insurance, mortgage insurance
, and any other applicable charges) before the reserves are completely exhausted. Often lenders will require anywhere from two to twelve months of payments in reserve. If you are applying for an FHA (Federal Housing Administration), there are no reserves required however, it makes your file that much stronger if you have at least 2 months reserves.
The most typical asset is a borrower’s checking
and savings account
. Other sources include retirement funds (401K, Individual Retirement Account
), investments (stocks
, mutual funds, CDs
) and any other liquid source of funds. Funds that have penalties for withdrawing must be considered conservatively and are evaluated at 70% or less of their value. Accounts such as pensions and other accounts and personal property
that lack liquidity may not be used as assets.
refers to the type of property
, value
, the use of the property and everything related to these aspects. Property type can be classified as the following in the order of risk from lowest to highest: single family residence, duplex
, townhouse
, low rise condominium
, high rise condominium
, triplex and four-plexes and condotels. Occupancy
is also considered part of collateral. A home can be owner occupied, used as second home
or investment
. Owner occupied and second homes have the least amount of default, while investment properties have higher occurrences of default. Depending the combination of occupancy and type of collateral, the lender will adjust the amount of risk they are willing to take.
Besides occupancy and property type, value
is also considered. It is important to realize price
, value
and cost
are three different characteristics of a home. Price is the dollar amount that a seller agrees to sell a house to another party. Cost is the dollar amount needed to build the home including labor and materials. Value, which is usually the most important characteristic, is the dollar amount that is supported by recent sales of properties that have similar characteristics, in the same neighborhood and appeal to a consumer. Under fair marketing circumstances when the seller is not in distress and the housing market is not under volatile conditions, price and value should be very comparable.
To determine the value, an appraisal
is usually obtained. In addition to determining the value of the property, it is the appraiser
’s responsibility to identify the market conditions, the appeal and amenities of the neighborhood and the condition and characteristics of the property. Value is determined by comparing recent sales of similar neighboring properties. The appraiser may make reasonable adjustments to the sales price of the other properties for lot size, square footage of the home, number of bedrooms and bathrooms and other additions such as garages
, swimming pools and decks
. It is underwriter’s responsibility to review the appraisal and request any further information necessary to support the value and marketability of the property. If the home needs to be foreclosed upon, the lender must be able to sell the property to recoup their losses.
The comparative analysis
of the collateral
is known as loan to value
(LTV). Loan to value is a ratio
of the loan amount to the value of the property. In addition, the combined loan to value (CLTV) is the sum of all liens against the property divided by the value. For example if the home is valued at $200,000 and the first mortgage is $100,000 with second mortgage of $50,000, the LTV is 50% while the CLTV is 75%. Naturally, the higher LTV and CLTVs increase the risk of loan. Furthermore, borrowers who contribute significant down payment
(lowering the LTV) statistically have lower incidents of foreclosure.
The type of the loan also may affect the LTV and is considered when evaluating the collateral. Most loans include payments towards the principal balance of the mortgage. These pose the lowest risk since the LTV is decreasing as the mortgage payments are paid. Recently, interest only mortgage have become increasingly popular. These mortgages allow the borrower to make payments that simply meet the interest due on the loan without making any contribution to the principal balance. In addition, there are loans that allow negative amortization
, which means the payments do not meet the interest due on loan. Therefore, the interest that is not paid is subsequently added to the principal balance of the loan. In this case, it is possible to owe more than the value of the home during the course of the loan, which exposes the lender to the highest risk.
To offset the risk of high LTV’s, the lender may require what is called mortgage insurance. Mortgage insurance insures the lender against losses that may occur when a borrower defaults on his or her mortgage. Typically, this is required on loans that have LTV’s that exceed 80%. The cost of the mortgage insurance is passed on to the borrower as an added expense to their monthly payment, but some banks allow what is called lender paid insurance, where the interest rate is higher in exchange for the lender paying the mortgage insurance. All government loans such an FHA and VA require mortgage insurance, regardless of the LTV.
. Many lenders will underwrite their files according to their guidelines, but to ensure the eligibility to be purchased by Fannie Mae and Freddie Mac, underwriters will utilize what is called automated underwriting. This is a tool available to lenders to provide recommendations on the risk of a loan and borrower and it provides the amount of documentation needed to verify the risk.
It is important to remember that the approval and feedback is subject to the underwriter's review. It is also the responsibility of the underwriter to evaluate the aspects of the loan that is beyond the scope of automated underwriting. In short, the underwriter approves the loan, not the automated underwriting.
On the other hand, automated underwriting has streamlined the mortgage process by providing analysis of credit and loan terms in minutes rather than days. For borrowers it reduces the amount of documentation
needed and may even require no documentation of employment
, income
, assets or even value
of the property
. Automated underwriting tailors the amount of necessary documentation in proportion to the risk of the loan.
s also offer reduced documentation loans which allows a borrower to qualify for a mortgage without verifying items such as income or assets. Naturally these are higher risk loans and often come with higher interest rates. Because less documentation is provided on the capacity of the borrower, there is a high emphasis on the credit
and collateral
. To mitigate the risk of reduced documentation loans, lenders will often not lend to higher LTVs and limit the loans to smaller loan amounts, compared to loans that are fully documented.
, it is up to the underwriter to assess the risk of the loan as a whole. Each borrower and each loan is unique and many borrowers may not fit every guideline. However, certain aspects of the loan may compensate for the lack in other areas. For an example, the risk of high LTVs can be offset by the presence of a large amount of assets. Low LTVs can offset the fact that the borrower has a high debt to income ratio and excellent credit can overcome the lack of assets.
In addition to compensating factors, there is a concept known as layering of risk. For an example, if the property is a high rise condo, occupied as an investment, with a high LTV and a borrower who is self-employed, the cumulative affect of all these aspects yields higher risk. Though the borrower may meet all requirements under the guidelines of the loan program, the underwriter must exercise caution.
There is an old saying in lending: If your portfolio does not have one foreclosure, you are not accepting enough risk. Underwriters should review a loan from a holistic point of view; otherwise they may turn down a loan that is high risk in one aspect but low risk as a whole.
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United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
is the process a lender uses to determine if the risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
of offering a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
, capacity and collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
.
To help the underwriter assess the quality of the loan, banks and lenders create guidelines and even computer models that analyze the various aspects of the mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.
Credit reports
CreditCredit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
is what the underwriter uses to review how well a borrower manages his or her current and prior debts. Usually documented by a credit report from each of the three credit bureaus, Equifax
Equifax
Equifax Inc. is a consumer credit reporting agency in the United States, considered one of the three largest American credit agencies along with Experian and TransUnion. Founded in 1899, Equifax is the oldest of the three agencies and gathers and maintains information on over 400 million credit...
, Transunion
TransUnion
TransUnion is the third largest credit bureau in the United States, which offers credit-related information to potential creditors. Like major competitors Equifax and Experian, TransUnion markets credit reports directly to consumers.- History :...
and Experian
Experian
Experian plc, formerly known as CCN Systems, is a global credit information group with operations in 36 countries. The company employs 15,500 people with corporate headquarters in Dublin, Ireland and operational headquarters in Nottingham, England and Costa Mesa, California, US...
, the credit report provides information such as credit scores, the borrower’s current and past information about credit cards, loans, collections, repossession
Repossession
Repossession is generally used to refer to a financial institution taking back an object that was either used as collateral or rented or leased in a transaction. Repossession is a "self-help" type of action in which the party having right of ownership of the property in question takes the property...
and foreclosures and public records (tax liens, judgments and bankruptcies). Typically, a borrower’s credit is highly related to the probability that the loan will go into default (failure to make monthly installments).
In reviewing a credit report, the credit score
Credit score
A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person...
is considered. The credit score is an indicator of how well a borrower manages debt. Using a mathematical model
Mathematical model
A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used not only in the natural sciences and engineering disciplines A mathematical model is a...
, the data regarding each item on the credit report is used to produce a number between 350 and 850, known as the credit score. Higher scores represent those with less risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
. When lenders refer to a representative credit score, they are referring to the median score. When multiple borrowers are involved typically the borrower with lowest median score is the one that is considered as the representative credit score. Other loan programs may consider the person that earns the most money, also known as the primary wage earner, that has the representative credit score. On many loan programs there are minimum score guidelines.
The most influential aspect of the credit report is quality of the credit on a person’s current housing. For an example, if the borrower already has a mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, whether or not the borrower has paid that mortgage on time is indicative of how well they will pay in the future. This also holds true with people that rent. A lender will typically analyze the most recent 12–24 months of the borrower’s housing history. Delinquencies during that time period are usually unacceptable.
In addition, the history of payment of loans and revolving credit
Revolving credit
Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to installment credit. Examples of revolving credits used by consumers include credit cards. Corporate revolving credit facilities are typically used to provide liquidity for a company's day-to-day...
is considered. A lender may require that a certain number of deposit accounts be opened for at least 24 months and have recent activity with on time payments to build a pattern of responsible use of credit.
The credit report also contains the borrowers past derogatory credit. This include collections, charge offs, repossession
Repossession
Repossession is generally used to refer to a financial institution taking back an object that was either used as collateral or rented or leased in a transaction. Repossession is a "self-help" type of action in which the party having right of ownership of the property in question takes the property...
, foreclosures, bankruptcies, liens and judgments. Typically, if any of these items are present on the report, it increases the risk of the loan. For more serious blemishes such as foreclosures and bankruptcies, a lender may require up to two to seven years from the date of satisfaction indicated by the report before approving a loan. Furthermore, the lender may require the borrower to reestablish the credit by obtaining a certain amount of new credit to rebuild their credit. It is also the prerogative of the lender to require that all collections, charge offs, liens and judgments be paid prior to closing the loan.
Income analysis
Capacity refers to the borrower’s ability to make the payments on the loan. To determine this, the underwriter will analyze the borrower’s employmentEmployment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
, income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
, their current debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
and their assets.
While reviewing the borrower’s employment, the underwriter must determine the stability of the income. People who are employed by a company and earn hourly wages pose the lowest risk. Self-employed borrowers pose the highest risk, since they are typically responsible for the debt and well-being of the business in addition to their personal responsibilities. Commission income also carries similar risks in the stability of income because if for any reason the borrower fails to produce business, it directly influences the amount of income produced. Usually if self-employment or commission income is used to qualify for the mortgage, a two year history of receiving that income is required.
Documentation of the income also varies depending on the type of income. Hourly wage earners who have the lowest risks usually need to supply paystubs and W-2 statements. However, self-employed, commissioned and people who collect rent are required to provide tax returns. Retired people are required to evidence that they eligible for social security
Social security
Social security is primarily a social insurance program providing social protection or protection against socially recognized conditions, including poverty, old age, disability, unemployment and others. Social security may refer to:...
and document the receipt of payments, while people that receive income via cash investments must provide statements and determine the continuance of the income from those payments. In short, the underwriter must determine and document that the income and employment is stable enough to pay the mortgage in years to come.
Furthermore, underwriters evaluate the capacity to pay the loan using a comparative method known as the debt to income ratio. This is calculated by adding up all of the monthly liabilities and obligations (mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
payments, monthly credit and loan payments, child support
Child support
In family law and public policy, child support is an ongoing, periodic payment made by a parent for the financial benefit of a child following the end of a marriage or other relationship...
, alimony
Alimony
Alimony is a U.S. term denoting a legal obligation to provide financial support to one's spouse from the other spouse after marital separation or from the ex-spouse upon divorce...
, etc.) and dividing it by the monthly income. For an example, if a borrower has a $500 car payment, $100 in credit and loan payments, pays $500 in child support and wants a mortgage with payments $1,000 per month, his total monthly obligations is $2100. If he makes $5,000 a month, his debt to income ratio is 42%. Typically the ratio must be below anywhere from 32% for the most conservative loans to 65% for the most aggressive loans.
Assets are also considered when evaluating capacity. Borrowers who have an abundance of liquid assets at the time of closing statistically have lower rates of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
on their mortgage. This is termed as reserves by the industry. For example, if your total mortgage payment is $1000 a month and you have $3000 left after you pay your down-payment and closing costs, you have 3 months reserves. Underwriter also looked closely at your bank statements for incidences of NSF's (non- sufficient funds). If this happens regularly, this is a red flag with the underwriter because this indicates that the borrower don't know how to manage their finances.
Furthermore, if the borrower’s employment is interrupted for any reason, the borrowers would have enough cash in reserve to pay their mortgage. The amount of cash reserves is qualified by the number of payments the borrower can make on their total housing expenditure (the total of the principal and interest payment, taxes, insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
, homeowners insurance, mortgage insurance
Mortgage insurance
Mortgage insurance is an insurance policy which compensates lenders or investors for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer...
, and any other applicable charges) before the reserves are completely exhausted. Often lenders will require anywhere from two to twelve months of payments in reserve. If you are applying for an FHA (Federal Housing Administration), there are no reserves required however, it makes your file that much stronger if you have at least 2 months reserves.
The most typical asset is a borrower’s checking
Cheque
A cheque is a document/instrument See the negotiable cow—itself a fictional story—for discussions of cheques written on unusual surfaces. that orders a payment of money from a bank account...
and savings account
Savings account
Savings accounts are accounts maintained by retail financial institutions that pay interest but cannot be used directly as money . These accounts let customers set aside a portion of their liquid assets while earning a monetary return...
. Other sources include retirement funds (401K, Individual Retirement Account
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
), investments (stocks
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
, mutual funds, CDs
CDS
-Computing and electronics:* Cadence Design Systems, American Electronic Design Automation software company* Chromatography data system, software to control chromatography instruments* Cockpit display system* Compact Discs...
) and any other liquid source of funds. Funds that have penalties for withdrawing must be considered conservatively and are evaluated at 70% or less of their value. Accounts such as pensions and other accounts and personal property
Personal property
Personal property, roughly speaking, is private property that is moveable, as opposed to real property or real estate. In the common law systems personal property may also be called chattels or personalty. In the civil law systems personal property is often called movable property or movables - any...
that lack liquidity may not be used as assets.
Collateral
CollateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
refers to the type of property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
, value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
, the use of the property and everything related to these aspects. Property type can be classified as the following in the order of risk from lowest to highest: single family residence, duplex
Duplex (building)
The term duplex can be used to describe several different dwelling unit configurations:A duplex house is defined as a dwelling having apartments with separate entrances for two families. This includes two-story houses having a complete apartment on each floor and also side-by-side apartments on a...
, townhouse
Townhouse
A townhouse is the term historically used in the United Kingdom, Ireland and in many other countries to describe a residence of a peer or member of the aristocracy in the capital or major city. Most such figures owned one or more country houses in which they lived for much of the year...
, low rise condominium
Condominium
A condominium, or condo, is the form of housing tenure and other real property where a specified part of a piece of real estate is individually owned while use of and access to common facilities in the piece such as hallways, heating system, elevators, exterior areas is executed under legal rights...
, high rise condominium
Condominium
A condominium, or condo, is the form of housing tenure and other real property where a specified part of a piece of real estate is individually owned while use of and access to common facilities in the piece such as hallways, heating system, elevators, exterior areas is executed under legal rights...
, triplex and four-plexes and condotels. Occupancy
Occupancy
Occupancy in building construction and building codes is the use or intended use of a building or part thereof for the shelter or support of persons, animals or property. A closely related meaning is the number of units in such a building that are rented or leased, or otherwise in-use...
is also considered part of collateral. A home can be owner occupied, used as second home
Second home
Second home may refer to:* Vacation property* Pied-à-terre* Second Home , an album by Marié Digby...
or investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
. Owner occupied and second homes have the least amount of default, while investment properties have higher occurrences of default. Depending the combination of occupancy and type of collateral, the lender will adjust the amount of risk they are willing to take.
Besides occupancy and property type, value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
is also considered. It is important to realize price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
, value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
and cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
are three different characteristics of a home. Price is the dollar amount that a seller agrees to sell a house to another party. Cost is the dollar amount needed to build the home including labor and materials. Value, which is usually the most important characteristic, is the dollar amount that is supported by recent sales of properties that have similar characteristics, in the same neighborhood and appeal to a consumer. Under fair marketing circumstances when the seller is not in distress and the housing market is not under volatile conditions, price and value should be very comparable.
To determine the value, an appraisal
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
is usually obtained. In addition to determining the value of the property, it is the appraiser
Appraiser
An appraiser , is one who sets a value upon property, real or personal. In England the business of an appraiser is usually combined with that of an auctioneer, while the word itself has a similar meaning to that of "valuer." In the United States, the most common usage relates to real estate...
’s responsibility to identify the market conditions, the appeal and amenities of the neighborhood and the condition and characteristics of the property. Value is determined by comparing recent sales of similar neighboring properties. The appraiser may make reasonable adjustments to the sales price of the other properties for lot size, square footage of the home, number of bedrooms and bathrooms and other additions such as garages
Garage (house)
A residential garage is part of a home, or an associated building, designed or used for storing a vehicle or vehicles. In some places the term is used synonymously with "carport", though that term normally describes a structure that is not completely enclosed.- British residential garages:Those...
, swimming pools and decks
Deck (building)
In architecture, a deck is a flat surface capable of supporting weight, similar to a floor, but typically constructed outdoors, often elevated from the ground, and usually connected to a building...
. It is underwriter’s responsibility to review the appraisal and request any further information necessary to support the value and marketability of the property. If the home needs to be foreclosed upon, the lender must be able to sell the property to recoup their losses.
The comparative analysis
Comparative analysis
Comparative analysis is type of analysis used in various of sciences and in different modifications:Criminology and forensics:* Comparative contextual analysis - criminology* Comparative bullet-lead analysis - forensicsSociology:...
of the collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
is known as loan to value
Loan to value
The loan-to-value ratio expresses the amount of a first mortgage lien as a percentage of the total appraised value of real property. For instance, if a borrower borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000/$150,000 or 87%.Loan to value is one of the key risk...
(LTV). Loan to value is a ratio
Ratio
In mathematics, a ratio is a relationship between two numbers of the same kind , usually expressed as "a to b" or a:b, sometimes expressed arithmetically as a dimensionless quotient of the two which explicitly indicates how many times the first number contains the second In mathematics, a ratio is...
of the loan amount to the value of the property. In addition, the combined loan to value (CLTV) is the sum of all liens against the property divided by the value. For example if the home is valued at $200,000 and the first mortgage is $100,000 with second mortgage of $50,000, the LTV is 50% while the CLTV is 75%. Naturally, the higher LTV and CLTVs increase the risk of loan. Furthermore, borrowers who contribute significant down payment
Down payment
Down payment is a payment used in the context of the purchase of expensive items such as a car and a house, whereby the payment is the initial upfront portion of the total amount due and it is usually given in cash at the time of finalizing the transaction.A loan is then required to make the full...
(lowering the LTV) statistically have lower incidents of foreclosure.
The type of the loan also may affect the LTV and is considered when evaluating the collateral. Most loans include payments towards the principal balance of the mortgage. These pose the lowest risk since the LTV is decreasing as the mortgage payments are paid. Recently, interest only mortgage have become increasingly popular. These mortgages allow the borrower to make payments that simply meet the interest due on the loan without making any contribution to the principal balance. In addition, there are loans that allow negative amortization
Negative amortization
In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
, which means the payments do not meet the interest due on loan. Therefore, the interest that is not paid is subsequently added to the principal balance of the loan. In this case, it is possible to owe more than the value of the home during the course of the loan, which exposes the lender to the highest risk.
To offset the risk of high LTV’s, the lender may require what is called mortgage insurance. Mortgage insurance insures the lender against losses that may occur when a borrower defaults on his or her mortgage. Typically, this is required on loans that have LTV’s that exceed 80%. The cost of the mortgage insurance is passed on to the borrower as an added expense to their monthly payment, but some banks allow what is called lender paid insurance, where the interest rate is higher in exchange for the lender paying the mortgage insurance. All government loans such an FHA and VA require mortgage insurance, regardless of the LTV.
Automated underwriting
Fannie Mae and Freddie Mac are the two largest companies that purchase mortgages from other lenders in the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. Many lenders will underwrite their files according to their guidelines, but to ensure the eligibility to be purchased by Fannie Mae and Freddie Mac, underwriters will utilize what is called automated underwriting. This is a tool available to lenders to provide recommendations on the risk of a loan and borrower and it provides the amount of documentation needed to verify the risk.
It is important to remember that the approval and feedback is subject to the underwriter's review. It is also the responsibility of the underwriter to evaluate the aspects of the loan that is beyond the scope of automated underwriting. In short, the underwriter approves the loan, not the automated underwriting.
On the other hand, automated underwriting has streamlined the mortgage process by providing analysis of credit and loan terms in minutes rather than days. For borrowers it reduces the amount of documentation
Documentation
Documentation is a term used in several different ways. Generally, documentation refers to the process of providing evidence.Modules of Documentation are Helpful...
needed and may even require no documentation of employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
, income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
, assets or even value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
of the property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
. Automated underwriting tailors the amount of necessary documentation in proportion to the risk of the loan.
Reduced documentation
Many bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s also offer reduced documentation loans which allows a borrower to qualify for a mortgage without verifying items such as income or assets. Naturally these are higher risk loans and often come with higher interest rates. Because less documentation is provided on the capacity of the borrower, there is a high emphasis on the credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
and collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. To mitigate the risk of reduced documentation loans, lenders will often not lend to higher LTVs and limit the loans to smaller loan amounts, compared to loans that are fully documented.
Approval decision
After reviewing all aspects of the loanLoan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
, it is up to the underwriter to assess the risk of the loan as a whole. Each borrower and each loan is unique and many borrowers may not fit every guideline. However, certain aspects of the loan may compensate for the lack in other areas. For an example, the risk of high LTVs can be offset by the presence of a large amount of assets. Low LTVs can offset the fact that the borrower has a high debt to income ratio and excellent credit can overcome the lack of assets.
In addition to compensating factors, there is a concept known as layering of risk. For an example, if the property is a high rise condo, occupied as an investment, with a high LTV and a borrower who is self-employed, the cumulative affect of all these aspects yields higher risk. Though the borrower may meet all requirements under the guidelines of the loan program, the underwriter must exercise caution.
There is an old saying in lending: If your portfolio does not have one foreclosure, you are not accepting enough risk. Underwriters should review a loan from a holistic point of view; otherwise they may turn down a loan that is high risk in one aspect but low risk as a whole.
IT systems
Banks generally use IT systems available from various vendors to record and analyze the information, and these systems have proliferated. Here's a primer on what many of them mean. These include the "loan origination system" (also called a loan operating system) (LOS) as well as other tools such as Fannie Mae and Freddie Mac's automated underwriting systems the "Desktop Underwriter" and "Loan Prospector". One example of a LOS is FiservFiserv
Fiserv, Inc. provides information management systems and services to the financial and insurance industries. Leading services include transaction processing, outsourcing, business process outsourcing , software and systems solutions. The company serves more than 16,000 clients worldwide...
's UniFi PRO.