Mortgage Underwriting: Managing Lender Risk

Understanding the process of mortgage underwriting is critical for any serious note investor. A thorough understanding of the basic concepts and process behind underwriting, will allow you as the investor, to feel safe and secure in your investments and obtain a more complete picture of how your investment operates. From the viewpoint of a mortgage loan originator (loan officer/account executive), mortgage underwriting is simply approving or rejecting a loan application; and of course the originator believes that every loan s/he takes is a great loan and therefore should be approved; which means that when a denial letter comes back from the underwriting department, the loan officer inquires about reasons for such denial and whether anything can be done to reverse the underwriter's decision. On occasion such a reversal may be possible, but quite frequently the underwriter's decision is final.

It is that finality which is often the source of a borrower's disappointment and a loan officer's dejection; but is at the same time, the source of an underwriter's power and influence within a mortgage lender's organization. Once a mortgage loan application lands on the desk of an underwriter, chances are that it is worthy of approval based on the process it has undergone to reach that stage, since it could have been stuck in the processing department for any number of reasons, including lack of required documentation.

However, having reached underwriting it will be reviewed, assessed, scrutinized and determined to be an acceptable risk or not. Most important among the steps taken to make such a determination is what the underwriter deems adequate enough income to meet guideline ratios or – if income threatens to stretch guideline ratios – highlight other areas of the loan application which can be used as compensating or redeeming factors (probability of continued employment, strong employment history, expectancy of promotion, etc.) to strengthen the loan.

Income requirements of the underwriting approval processes are most important because it matters less that a loan applicant's credit score is 780, if the income s/he will use to repay the loan is inadequate. Moreover, recent studies show this to be the case as reported by Kenneth R. Harney, in his Washington Post website article, 'Debt ratios, not credit scores, are the most worrisome factor for mortgage applicants,' in which he states that “Nearly 60 percent of risk managers in the FICO study rated excessive DTIs as their No. 1 concern factor; that’s five times the percentage who picked the next biggest turnoff.”

The survey referred to in this July 18 article was conducted by “credit-score giant FICO,” and questions were directed to “credit-risk managers at financial institutions.” DTI (Debt to Income) ratios are established by banks and other secondary market agencies (Fannie Mae, Freddie Mac, and FHA) to determine acceptable income requirements for mortgage lending. But it is a well-known fact that underwriters evaluate more than income to make an approval decision.

This fact was best expressed in the article 'Mortgage underwriting in the United States,' in which the writer states that “Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral.” Having discussed one of these C's, capacity or ability to repay based on income, it is time to shed some light on the other two; and even though the collateral is as important as any other component in the approval process, it is more the function of a certified appraiser than the underwriter, to determine its adequacy. So the appraisal underwriting will be discussed later while we turn our attention to underwriting the credit report.

Since the introduction of credit scores to real estate financing, manual underwriting has been employed less, and the criteria for this underwriting method have, to a certain extent, been incorporated into the automated models. However, the ability to manually underwrite a mortgage loan is still relevant, since it is a requirement for being certified as an underwriter, and it is used to process FHA-insured mortgages, and mortgages to Veterans and their eligible spouses; mortgages which are guaranteed by the VA (Veterans Administration).

Guidelines established by the FHA (Federal Housing Administration) permit an underwriter to consider a borrower for approval whose median credit score on a tri-merged (the 3-bureau combined) report is as low as 580, a score that is taboo to conventional loan underwriters. According to HUD Mortgagee Letter 2013-05, issued last year, a borrower with a “credit score below 620,” and “debt-to-income ratio [which] exceeds 43.00% must be manually underwritten. And in order for an underwriter to adhere to this guideline, s/he must make “common sense” evaluations and use discretion to approve or deny a loan, while keeping in mind the risk s/he has to balance.

Manual underwriting requires an underwriter to ask for more documentation and explanations based on a variety of findings in a borrower's credit report. These additional requirements could include: explanation for all late payments of 30-days or more; any existing or past collection accounts; satisfied judgments; repossession of an auto, if applicable; discharged chapter 7 or 13 over two years; insurance loan repayments; loan appearing on a pay stub (maybe from the union); rent payment lateness(es) as evidenced by canceled rent checks/rental verification; and any other piece of information the underwriter can gather to strengthen a loan with lower than the recommended scores.

Underwriting the property appraisal report requires an underwriter to confirm or dispute certain representations made by the property appraiser. S/he reviews data collected by the appraiser on the basis of adjustments made to justify value; relevance of comparable properties; number of rooms as they relate to family size; whether basements and attics are suitable as living units; and whether the overall collateral is enough – based on value and condition – to support the loan. There are other aspects to how mortgage loan underwriters do their jobs, but the three mentioned in this article receives most of their attention.


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