What Is the Underwriting Process of a Mortgage?
Mortgage underwriting is a process in which a lender examines a potential borrower’s eligibility for a loan. To do this, lenders typically look at three major factors: credit, capacity, and collateral. Now that you know these factors, let’s take a deeper dive into each.
Lenders Look at Credit to Determine a Borrower's Trustworthiness
To examine a borrower's credit, a lender will take a look at a lender’s credit reports and credit score -- which will have information about their past and current debts, including credit card usage, car loans, and any past foreclosures or repossessions they’ve been involved in.
Capacity Is an Important Measure of a Borrower’s Ability to Repay Debts
Capacity refers to the a borrower’s potential ability to repay their loan. In an attempt to determine a borrower’s capacity, a lender will look at their income, their current employment, their employment history, their debts, and their assets.
One important part of this process is income verification, which is the process in which a borrower actually proves how much they make. For regular, salaried/hourly full-time employees, this process is somewhat straightforward, and typically only requires pay stubs and/or W2 statements.
In comparison, self-employed borrowers may have to submit tax return forms including Schedule C, Schedule E, and K-1 documents. And, if you’re retired, you’ll likely have to submit proof that you’re eligible for social security or have other stable streams of income with which to pay your mortgage.
Another major measure of capacity is a borrower’s debt-to-income ratio (DTI), which compares their monthly debt obligations to the amount of money they bring in each month. Most lenders prefer borrowers with a DTI of 43% or less. Despite that, some lenders will accept borrowers with a DTI of 50% or more, though they would likely have to have excellent credit, and may also have to deal with higher interest rates to compensate the lender for their increased risks.
Collateral Provides Lenders a Degree of Financial Security
When lenders look at collateral, they look at the value of the property, the type of property, and the property’s use. For example, single family, owner-occupied homes are considered relatively low-risk, while other types of residential properties, such as duplexes, triplexes and condos are considered somewhat more risky. In addition, investment properties are considered much riskier than owner-occupied homes, since a borrower is much more likely to stop paying the mortgage on a home if they aren’t currently living in it.
Lenders also look at another formula, loan-to-value (LTV) ratio, in order to evaluate the security of a property as collateral. LTV compares the size of the loan with the current, appraised value of the property. LTV requirements vary between lenders, but generally, the better credit score you have, the higher LTV you can have and still get approved for a home loan.
Lenders Balance Each of These Factors to Determine Loan Approval
Credit, capacity, and collateral are all essential to the mortgage underwriting process, but you don’t need to ace every category in order to be approved for a mortgage. For example, if you have great credit and a good income, you may be able to get away with purchasing a riskier property, such as a duplex or triplex.
And, if you have great income, it may not be the biggest deal that your credit isn’t perfect, especially if you’re trying to buy a single family home. In the end, knowledge is power -- so now that you know what lenders are looking for, do what you can to improve yourself in each of these three categories -- and getting approved for a mortgage should be a breeze.