When a person applies for a loan, he is termed to be an endorser or applicant of the loan. A person or organization who lends the loan is known as the lender. In between the lender and borrower, sometimes, there is an existence of a loan agent. After the application is made, the agent and the lender undertakes a very important procedure known as underwriting. In some cases, the underwriting is done by both, the lender as well as the agent, but in some cases, only the agent does the procedure.
It must be noted that there is no single loan underwriting definition, and the concept of underwriting is used for a varied number of reasons in the world of finance.
The underwriting procedure basically involves ascertaining the creditability and capability of the borrower to repay the loan. In cases where the loan is a commercial or mortgage loan, the projected value of the collateral is also forecast. Thus, basically, the underwriting process involves ascertaining the recovery of money, and its rate of recovery. The process in itself is quite intricate and difficult. Loan underwriting is usually conducted for bigger loans, such as mortgage and auto loans. The smaller loans, such as cash advance and payday loans, however, do not have this complex underwriting processes. Instead, a simple approval process is used. In the United States, Freddie Mae and Fannie Mae, along with the Federal Housing Administration, provide the detailed underwriting guidelines.
The best way to understand an underwriting procedure is to understand the considerations and aspects of loan underwriting. The guidelines that are provided by the aforementioned institutions are based upon the following aspects.
- Income: One of the most important aspects that is considered during the process is the income of the borrower. The loan’s installment is also calculated as per the income of the borrower. The size of the loan, i.e., the total amount that is lent, the down payment, and rate of interest are all decided upon the income of the borrower.
- Debt to Income Ratio: The second important factor that is considered is the debt to income ratio, which is the ratio between the monthly payable debts and monthly income. Debt to income is sometimes also calculated for the entire year. The intention of calculating such a ratio is that it gives the perfect amount of income that is going to be used to pay the debt.
- Employment and Source of Income: A very important aspect that is considered by the underwriters is the employment status of the borrower, and the source of income. Underwriters also further analyze the income projection and the growth of income rate, in cases where the loan is very long-term.
- Credit Report: The credit report of a person considers two important facts―the credit history and the credit rating. The history is a record of all the previous credit related activities of the borrower. The rating is a figure that denotes the credit weight of the borrower. A rating is usually expressed in the form of a credit score, and is calculated on the basis of the credit history, late payments, and defaults.
- Projection of the Property: The value projection of the property is also considered by the underwriters. This projection is taken into consideration in cases where the asset is a real estate. There are cases where mortgage and home loans are defaulted by the borrower, or foreclosure has to be initiated. In such a case, the lender takes over the ownership of the property, and sells it off to recover losses. The projection of the value of the property, is thus, an important aspect of mortgage loan underwriting.
It must be noted that commercial loan underwriting is different and much more complicated than the underwriting procedure for individual customers.