Understanding Loan Underwriting



Chapter 3: Understanding Loan Underwriting

[by Richard Genz]

Chapter 3 presents key concepts that ground loan underwriting practices, and will explore how lenders apply these concepts with standard documents, procedures, and information technology. The chapter will highlight what the industry’s norms suggest for HOME program design.

Loan Origination

The loan origination process determines whether the assisted borrower qualifies for mortgage credit. This section discusses how lenders weigh the different facets of mortgage risk.

Elements of Mortgage Risk

The key to profitable mortgage lending is pricing loans according to their risk of default. Default risk is tied to three things:

▪ Willingness to pay (evidenced by credit history)

▪ Ability to pay (income vs. expenses)

▪ Collateral (downpayment amount, home value)

Each of these is reviewed carefully during the process of loan underwriting.

Evaluating Credit

Methods for determining a borrower’s willingness to honor credit obligations have changed over the past 10-15 years. Mortgage lenders used to collect basic credit information and then decide for themselves whether there were too many unexplained late payments in a given period of time. To assist first-time homebuyers having little credit history of any kind, lenders would sometimes consider the timeliness of utility or rent payments.

During the 1990’s, credit scores became the dominant way of assessing an applicant’s willingness to pay. Independent analytical firms developed the equations used to generate these scores by comparing actual performance of past loans with actual borrower credit records. The use of credit scores has grown rapidly over the past ten years as their contribution to lender profitability has become clear.

Credit scores from 300 to 850, worst to best, are assigned to assess the probability of loan default. For example, a credit score of 670 is in the 30th percentile of all scores. Consumers with this score have proven to be three times more likely to be 90 days late on payments than those with average scores. The accuracy of credit scores has been verified by scoring large portfolios of existing loans, and then comparing score predictions to actual loan performance.

>>insert text box. Credit scores are often referred to as FICO scores, named after a major provider, Fair, Isaac and Co.> insert text box. PJs that pre-screen potential borrowers may find that their assessment of borrower qualifications is more liberal than the one eventually applied by lenders. This can be especially true for lenders who are unfamiliar with typical household budget profiles in the particular market a program is designed to serve. ................
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