Mortgage underwriting 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. Because large securitizers such as the GSEs and other banks are large purchasers of loans from originators, and because many originators lack the balance sheets to hold onto loans for extended periods, automated underwriting guidelines are a crucial determinant of whether a mortgage will be made and at what price. In the U.S. the mortgage underwriting processing is done by a software called Automated Underwriting System (AUS). There are 2 AUS systems, and algorithms designed for this purpose, the first one Desktop Underwriting (DU) is designed by Fannie Mae and Loan Prospector (LP) by Freddie Mac. Some lenders still manually underwrite Manually Underwriting VS AUS the loan if the borrower doesn't pass the AUS but has additional compensating factors to be able to obtain the loan.
Credit reports Credit 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 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 (also called Listing 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 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 employment, 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. Although a bonus (sometimes it is indicated as "incentive pay" by many corporations) is part of the paystub income, a two-year employer verification is also 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 those who collect rent are required to provide tax returns (Schedule C, Schedule E and K-1). Retired individuals are required to prove they are eligible for social security and document the receipt of payments, while those who 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 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, her total monthly obligations is $2100. If she makes $5,000 a month, her 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, with a total mortgage payment that is $1,000 a month and the borrower has $3,000 left after paying the down payment and closing costs, the borrower has three months reserves. Underwriters also look closely at 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 doesn't know how to manage his or her finances.
When a borrower receives a gift for the down payment the assets need to be verified. Any large deposits, in fact, showing on bank statements will require an explanation from the borrower.
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 his or her 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 a borrower is applying for an FHA (Federal Housing Administration), there are no reserves required.
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.
Collateral Collateral 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, PUD, 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 upon 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. 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 the 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.