Loan Underwriting: Definition, Process & Purpose

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson we will look at the definition of loan underwriting. We will also explore how and why lenders use the process before extending credit to buyers in the form of a mortgage.

Loan Underwriting Definition

If you've ever been preapproved for a mortgage and proceeded to buy a house, you know the mortgage isn't done just because you've been preapproved. Before the buyer can get financing settled for a home purchase, the loan application must clear underwriting. Loan underwriting is the process of a lender determining if a borrower's loan application is an acceptable risk. Underwriters assess the borrower's ability to repay the loan based on an analysis of their credit, capacity, and collateral. The underwriter can make a final decision without giving equal weight to each consideration. Weaknesses in one area can be offset by another.

Credit

Credit refers to how the borrower currently handles debt as well as their past history. This information is pulled from the credit reports generated by three credit reporting bureaus: Equifax, TransUnion, and Experian. The underwriter looks not only at the credit score but also at the content of the credit history. Has the borrower paid credit cards and car loans on time? A strong history of reliable on-time payments improves the borrower's chance of getting the loan. Has the borrower ever had any debts go into collections, had a car repossessed, or declared bankruptcy? These could damage the chance of getting the loan or motivate the lender to offer financing at a higher interest rate.

Capacity

Capacity refers to a borrower's ability to repay the loan. In this area the underwriter considers the borrower's income, employment status, and current debts and assets. This information is sourced from the loan application and the borrower's credit reports.

A self-employed borrower is more of a risk for a lender than an employed borrower who earns a wage or salary. Lenders typically want to see at least two years of stable self-employment history to ensure the borrower can earn a consistent minimum income and demonstrate potential for continued income. In either case, the underwriter will need to verify the last two years of work, and can use pays stubs and tax returns or contact the employer to confirm this.

The other major part of capacity is does the amount of the monthly payment represent too much of a borrower's monthly income? Lenders typically don't want to see a debt-to-income ratio beyond 43%. What this means is if a borrower earns $4,000 a month, his or her mortgage payment plus all other monthly debt payments should not exceed $1,720, which we calculate by taking the total earnings ($4,000) and multiplying that figure by 43% (or .43). If the borrower has car payments, student loan payments, and/or high credit card balances, the maximum mortgage amount the borrower can draw will be limited to that maximum ratio.

Why is the debt to income ratio such a major focus? Lenders assume that at a given income the buyer will have a fixed ratio of living expenses, such as food, utilities, transportation, clothing, etc. If borrowers become overextended, they will pay for these items before they pay their mortgage. Setting a limit on the debt-to-income ratio limits the lender's risk of nonpayment.

Collateral

If you have a credit card, what recourse does the bank have if you don't pay? Not a whole lot. Which is why even though you are shopping for a home that costs six figures you almost certainly can't just put it on a credit card. Collateral is something of value put up against a loan in case of default. In the case of a mortgage, the property is the collateral. If you don't pay the mortgage, the lender can take the property and sell it to avoid losing money.

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