Mortgage Loan Underwriting
After the information on the loan application has been validated, the value of the property has been confirmed, and the title search has been completed, the loan is ready to be underwritten. Usually, a trained professional reviews all of the information, analyzes the credit worthiness of the borrower, and renders a decision on the loan request. Increasingly, much of the analytical tasks of underwriting is performed by technology through artificial intelligence and use of databases. There are generally secondary market underwriting guidelines, but many variables are considered in the analysis. The following outlines some of the basic areas and items considered in the process:
Monthly Housing Expenses and Total Debt Obligations: One of the first things an underwriter determines is the borrower's proposed monthly housing expenses and total monthly debt obligations.
- Housing expenses: These include the monthly principal and interest payments that are stipulated on the mortgage note. In addition, the monthly housing expenses include a monthly amount for the property taxes and hazard insurance (1/12 of the annual taxes and insurance). There may be other expenses, such as condominium fees, homeowners fees, special assessments, etc., that are included.
- Monthly debt obligations: These include monthly credit obligations, such as installment payments, revolving charge cards, or other borrower obligations that will continue longer than 10 months. Usually, 5% of the current balance of a revolving charge account is used for the monthly payment.
- Total monthly debt obligations: This combines the monthly housing expenses and monthly debt obligations.
Monthly Income: One of the most important components of the loan underwriting process is determining the borrower's monthly income. The income of all borrowers and co-borrowers is included in the calculation. The income can be derived from several sources, but it must be supported by historical documentation and have a high likelihood of continuation. The following outlines the types of income that are used and the means to support them:
Income to Debt Ratios
- Salary: Income derived from any kind of salary, whether monthly, weekly or hourly is acceptable. Two year employment history is usually required.
- Commission and bonus: Commissions and bonuses can be used for income. The underwriter will average the last two years of income shown on federal income tax returns and the year-to-date earnings from the written verification of employment or paystubs.
- Self-employment income: Generally, the underwriter will average the income derived through self-employment for the last two years from the applicant's federal tax returns and the year-to-date earnings from a profit and loss statement on the business. Usually, underwriters will take into consideration the income trends in the business, as well.
- Other income: Other income can be used for loan qualification. Income derived from rental properties, interest, dividends, pensions, and social security can be used.
: After determining the monthly income of the borrower and any co-borrowers, the monthly housing expenses and the total monthly debt obligations, the underwriter calculates two ratios that are helpful in the loan underwriting process.
- Primary Housing Expense (PHE)/Income Ratio(I): This ratio is the result of dividing the housing expenses for the proposed loan by the monthly income of the borrower(s). For example, if the primary housing expenses are $1,000 and the total monthly income is $4,000, the ratio will be 25% ($1,000/$4,000 = 25%).
- Total Obligations (TO)/Income Ratio(I): This ratio is the result of dividing the housing expenses for the proposed loan plus the borrower(s) other monthly credit obligations by the monthly income of the borrower(s). For example, if the total obligations of the borrower is $1,400 ($1,000 for housing expenses and $400 for other credit obligations), the ratio would be 35% ($1,400/$4,000 = 35%).
Qualifying ratios are only one component of the underwriting process and many other variables are considered in the final decision. Ratios are used as guidelines and can frequently be much higher than guidelines.
Funds to Close: When the proposed loan is being used to finance the purchase of a home, underwriters will determine the source of funds for the down payment and closing costs. The following are acceptable sources of funds for closing:
- Cash: Cash in any depository institution or investment company is acceptable.
- Stocks, bonds, mutual funds, etc.: Cash equivalent investments are acceptable forms of funds. They can be validated through statements from investment companies for the last two months.
- Sale of existing property: Many times the source of funds for the down payment on a home comes from the equity in a property that will be sold. The sales price of the property being sold is indicated on the loan application and any existing loan is verified on the credit report or through a verification of previous mortgage
- Gift from family members: Gifts from family members for the down payment and/or closing costs are acceptable so long as there is no requirement for repayment. Some loan programs limit the amount of gift funds allowed.
Credit Analysis: Another very important part of the underwriting process is determining the creditworthiness of the borrower. Loan underwriters review the borrower's credit report to find evidence of debt repayment behavior. Some of the important areas that are reviewed are:
- Past and existing mortgage debt: The past repayment history on mortgage debt can be a good indication of a borrowers attitude toward mortgage obligations. A good payment history on mortgage debt is very important in the credit analysis. Generally, payments received 30 days past the due date are reflected in the credit report as late. Lenders vary in strictness, and some may not allow any late mortgage payments, while others will allow 1 or 2 in the last two years if there is a good explanation.
- Installment and revolving credit: Other items on the credit report can also indicate a borrower's attitude toward credit obligations. Credit reports indicate the outstanding balance, current balance, and terms of payment on the borrower's revolving and installment debt. Underwriters review these credit obligations to determine the borrower's patterns of credit use and repayment behavior. Revolving credit encompasses department store and bank credit cards. Installment credit encompasses longer term credit with structured payment plans, such as car loans. Generally, underwriters are not concerned over isolated and minor slow payments indicated on the credit report.
- Collections, repossession, foreclosures and bankruptcies: Credit reports also indicate public records such as collections, repossessions, foreclosures, and bankruptcies. Though these items may indicate past credit problems, they sometimes have valid explanations. Underwriters may require a letter of explanation on items noted in the public records. Many times consumers have re-established credit and have an excellent payment history on their current obligations.
Underwriting the Appraisal: Generally, underwriters are not professional appraisers and do not re-appraise the property. They will review the appraisal to assure that it meets the requirements of the investor and sometimes request additional information to substantiate the value. They may request that a second appraisal or review appraisal be performed. If they believe that the value can not be substantiated, a review appraisal can be completed from a site inspection or review of the written appraisal. In both cases, another professional appraiser will perform the review.
Compensating Factors: The underwriters consider many variables in their analysis. No two borrowers have the same credit and income profiles and underwriters use all of the information in the loan file to render a decision. Many times, borrowers fall outside the guidelines, but have strong compensating factors that reflect low credit risk. Some compensating factors are history of savings, long-term job stability, history of making monthly credit payments that equal or exceed the proposed payments, a substantial down payment, or a large cash reserve after the close of escrow.
Final Credit Decision: After the underwriter has reviewed the entire loan package, there can be four outcomes:
- Approval: If the loan is "picture perfect" and the underwriter has no questions, the loan will be approved with no conditions.
- Approved with conditions (the most common response): There are two types of conditional approvals: (a) If the underwriter needs additional documentation before a final credit decision can be made, a "prior- to document" conditional approval will be rendered. In essence, the loan documents will not be prepared until the condition has been satisfactorily met. An example of a "prior to document" condition could be a pay stub to validate the borrowers income. (b) If the loan can be approved, but a condition must be met prior to closing, a "prior to funding" conditional approval will be rendered. In this case, the loan documents will be prepared and sent to the closing agent, but the lender will not fund the loan until the condition has been met. An example of a "prior to closing" conditional approval could be proof of sale of existing home where the equity will be used as the down payment.
- Suspended: Sometimes the underwriter will be unable to make a decision on a loan file because it is either incomplete or there are many unanswered questions. In these cases, the underwriter will ask for additional information from the borrower before an underwriting decision is made. An example of a suspension may be large gaps in the borrower's previous employment history and no tax returns to indicate the place of employment.
- Denial: Underwriters will be unable to approve a loan if the loan file has substantial deficiencies and does not meet the minimum standards of the lender or the lender's secondary market investors. Most lenders require that a second underwriter review the loan package before a final denial is communicated to the borrower. Denial letters with the reason for denial are sent to borrowers within 3 days of the final credit decision. Underwriting criteria can be different among lenders and a borrower may find other acceptable alternatives in the market place.