As you’re going through the loan process or in the research stage, you may have come across the term “underwriting.” This process is an important part of the loan process where lenders determine whether you qualify for a loan.
Let’s take a closer look at what underwriting is, how it works and what you can expect during the process.
What is underwriting?
Before going into detail about what an underwriter does, let’s first define underwriting. It typically happens behind the scenes, but the borrowers submit documents and answer questions so the underwriters can do their jobs.
An underwriter looks at a borrower’s financial details, such as their income, assets, debts and information about the potential loan in order to determine the risk level. The underwriter makes sure the lender is not taking on too much risk, which means the borrower isn’t taking on a loan they can’t afford. If the underwriter determines the borrower is too high a risk, the loan request could be denied, or approved at a higher interest rate.
The underwriter’s specific tasks are:
- Examining applications
- Vetting personal details
- Requesting a home appraisal
- Verifying employment and income
- Examining a borrower’s credit history
- Looking at a borrower’s debt-to-income ratio (DTI)
- Verifying assets and down payment amount (if applicable)
- Evaluating risk using software
How underwriting works
Aside from assessing the risk of the applicant, underwriters also do research to determine whether to approve or deny a loan. This research is to help arrive at a sound decision, such as determining a fair interest rate for loans, making sure premiums will be the true cost of insuring a policyholder, and ensuring there is a market for investments by pricing risk accurately.
Risk is important because it’s the lender’s way of judging the value of a loan. If the risk is too high, then an underwriter would deny the application or stop it from moving further in the approval process. For instance, an insurance underwriter will look at an applicant’s health history and habits, or a loan underwriter will look at the type of collateral available. The idea is for a company or lender to be able to remain financially stable or profitable if it approves a loan or insurance policy.
Types of underwriting
The two times consumers come into contact with underwriters are for loan and insurance underwriting. For investors or financial institutions, underwriters determine the risk of business loans or pricing securities.
This type of underwriting is where underwriters evaluate an applicant to assess their risk for life, health, homeowner, rental, or other types of insurance. The risk is based on how often an applicant is likely to file a claim, and whether the claims will be large. It also involves looking at how much coverage the applicant wants, their premiums, and the likelihood these claims will be paid.
Here’s how assessing risk may work for different industries:
- Life insurance: Underwriters look at an applicant’s age, health, occupation, lifestyle, hobbies, family medical history, and other physical traits.
- Health insurance: Underwriters may look at pre-existing conditions and type of insurance plan.
- Others: Underwriters tend to look at the likelihood of accidents or claims, environmental impacts, or potential damage to assess the scope for a policy.
Loan underwriting specifically looks at potential applicants and assesses them on their borrowing behaviors. More specifically, underwriters look at an applicant’s income, credit history, assets, collateral provided and the loan size to determine how likely they are to pay back the loan.
If there is collateral provided, the underwriter will also assess whether the property will be able to recoup the value of loan in the event the borrower defaults.
Investment firms and investors use securities underwriters in order to determine how profitable an investment may be. It usually involves looking at securities given by a company who is trying to attempt an initial public offering (IPO). The investor wants to assess the risk so that it can sell these securities to the market for a profit.
What is the mortgage underwriting process?
The mortgage underwriting process involves looking at various aspects of a borrower's financial situation to assess the risk of the loan for the lender. More specifically, the underwriter looks at your income, assets, existing debt, and the value of the property being financed.
An underwriter will check to see if an applicant has enough income to pay the mortgage payments in addition to their other financial obligations. Underwriters will look for proof of income — typically W2s for those working full-time — for the past two years.
Applicants who are self-employed may be required to provide additional proof such as tax returns, bank statements, profit and loss statements and K-1s depending on the type of business. This type of income source is typically considered riskier since it doesn’t necessarily provide a predictable source of income.
Assets are important as these could be used in case an applicant defaults on their payments as well as proof they can afford the closing costs. In other words, underwriters factor these into an applicant’s risk profile and may look at assets such as stocks, checking and savings accounts, real estate, and other personal property which can be converted into cash.
When it comes to a home purchase, appraisals are almost required because it offers protection for both the buyer and lender. It helps to ensure that the buyer only borrows what the home is truly worth. The appraisal is done by a third-party and compares similar properties that have been sold within a few miles in the past six months to arrive at a fair market price for the home being purchased.
Once the appraisal is complete, the amount is compared to the mortgage amount. From there, the underwriter will determine whether to proceed with the application process.
An applicant’s credit history is an important indicator of their risk, since it provides a picture of how responsible someone is with credit. The higher the score, the less risky the applicant will seem since it is an indicator they’ve made on-time payments on their debt.
Underwriters will have minimum score requirements, though they’ll differ depending on the type of loan.
Credit history will also be used to determine the debt-to-income (DTI) ratio, which compares how much of the applicant’s monthly income goes towards loan payments. The DTI is used to assess whether the applicant can afford to take on another loan. The higher the DTI, the riskier the applicant is deemed to be.
How long does underwriting take?
Underwriting timelines often differ because they are based on various factors, such as the type of underwriting conducted, as well as what information the underwriter needs to verify. Some aspects an applicant may be able to control, however, such as how efficiently they can provide the underwriter with the required information.
In most cases, the sooner all required documentation is provided, the sooner the underwriting process may be completed.