Extending loans to your customers usually requires a lot of screening—and even more paperwork (AKA, lots of your time).
To ease this burden, lenders employ professional underwriters to dive deep into borrowers' financial history and ascertain whether they can repay the loans they've applied for.
The underwriter's unbiased opinion gives you a clear picture of the borrower's financial situation and their potential risk before recommending whether to grant the loan.
So, what do underwriters do and what do they look for when reviewing loan applications? Read on to find out.
What does an underwriter do?
Underwriting is the process lenders use to decide if a borrower is eligible for a loan and establish the amount of credit to extend to them.
Typically, underwriters—professionals who specialize in risk analysis—carry out this process, analyzing data about the borrower using manual or automated underwriting methods.
For example, if a borrower submits a mortgage application, an underwriter will review their finances to assess how much of a risk the lender will undertake should they give them the loan. The underwriter helps the lender decide whether to approve the loan and works with the borrower to ensure they submit all the required financial documentation.
Ultimately, the mortgage underwriter ensures the borrower doesn't close on a mortgage they can't afford. If they don't qualify, the underwriter can deny the loan.
Stages of the underwriting process
The underwriting process involves several stages, including:
- Pre-qualifying the borrower for the loan
- Receiving the borrower's completed loan application
- Verifying the borrower's income and assets
- Conducting appraisals
- Submitting underwriting decisions
To put all this into perspective, here's an overview of each of these stages before an underwriter submits their lending decision.
Pre-qualify the borrower for the loan
This initial stage involves evaluating the borrower's eligibility for a loan based on their financial history and creditworthiness. The borrower will submit documents about their:
- Income
- Assets
- Debts
- Credit score
The underwriter will review the borrower's financial profile and run a credit check. However, this stage is simply an indication that the borrower could be approved for a loan, and additional paperwork may be required upon pre-approval—provided the borrower's situation doesn't change.
Receive the borrower's completed loan application
At this stage, the borrower has been pre-qualified and will need to complete and submit a loan application.
On the application, the borrower will include more detailed information about their finances, including their assets, debts, employment, and credit history.
Verify the borrower's income and assets
The next step is to check and confirm the borrower's financial status, verifying the accuracy of the information on the financial documents they provide—including bank account statements and tax returns.
Underwriters will also consider assets, such as money in bank or investment accounts, retirement savings, stock ownerships, cash value of insurance policies, and more.
If deemed qualified, the lender will issue a pre-approval letter stating the amount they're willing to extend to the borrower based on their financials.
Conduct appraisals
Once the underwriter verifies the borrower's information, they'll determine if they meet the lender's criteria by evaluating financial factors, including their credit score and debt-to-income ratio.
In the case of a mortgage loan application, the underwriter will appraise the property to assess whether the amount they plan to pay matches the house's condition and other homes in the vicinity. They'll also conduct title searches through a title company to check whether there are legal claims on the property and ensure it's transferable.
Submit underwriting decision
Based on the underwriter's analysis, the lender will deliver one of these decisions:
- Approved: Give the borrower a loan offer with terms and conditions. Sometimes lenders can give conditional approvals asking for additional documentation like pay stubs, proof of insurance, tax forms, and more.
- Denied: Deny the borrower the loan for various reasons, such as too much risk.
- Suspended: A decision to suspend might mean some of the borrower's information is missing and/or wasn't verifiable. In such cases, the lender can advise the borrower how to reactivate their application.
The final step is closing day when the lender funds the borrower's loan and any pending closing costs are settled.
This brings us to the next thing: what documents do underwriters review and why? Let's look at the relevant documents an underwriter looks for throughout the underwriting process.
What do underwriters look for in loan applications?
Consumers are taking out more loans, particularly after the pandemic.
LendingTree found that personal loan growth spiked by 15.2% in 2021 after dropping 7.6% in 2020. In addition, mortgages make up 72.7% of the total consumer debt while personal loans make up the smallest sliver—a little over 1%.
This shows the extent of consumers' borrowing appetite to finance their purchases, which is why lenders subject them to the underwriting process.
But what, exactly, do underwriters look for when reviewing a borrower's loan application and financial documents?
Simply put, they want to know the person can repay the loan. So, they find a borrower with the lowest possible defaulting risk.
A low-risk borrower has a higher chance of getting their loan approved with better terms like higher loan limit or lower interest rates. High-risk borrowers may qualify for smaller loans at higher interest rates or risk denial altogether.
To understand how underwriters determine the potential risk a borrower poses, here's what they look for in their evaluation.
Income
Underwriters want to know how much a borrower makes and how often. Typically, they'll ask the applicant to provide:
- W-2 forms
- Recent pay stubs
- Leave and earnings statements
- Recent bank statements
- Federal income tax returns (for self-employed or business owners)
W-2s from the last two years, along with two most recent pay stubs and bank statements, help underwriters evaluate a borrower's finances and past credit decisions. It also determines whether the borrower has enough money to cover monthly loan repayments.
Self-employed customers or those with a sizable share in a company will furnish profit and loss sheets, balance sheets, K-1s, and their personal and business tax returns. The underwriter can verify the borrower's income and employment situation from these documents.
Bank statements
When a borrower applies for a loan, evaluating their two months of recent bank statements verifies they can pay the down payment, closing costs, and mortgage payments. If the statements have no issues, the lender is likely to approve the loan.
However, there are certain red flags that underwriters check for, such as:
- Insufficient funds fees
- Bounced checks
- Large, undocumented deposits
- Monthly payments to non-disclosed or individual credit accounts
Bank statements aren't just for personal savings accounts but checking, money market, and any other accounts holding funds the borrower will use to qualify for the loan.
Like underwriters, loan officers also scrutinize these bank statements to verify the borrower's savings and cash flow check for unusual activity, and recent debts.
Assets
Underwriters also review the borrower's assets to ensure they can make payments on their loans. The assets can help the borrower secure a loan approval because the lender can sell the property for cash if they default on their payments.
Some things underwriters might view include:
- Savings and checking accounts
- Stocks
- Personal property
- Real estate
Credit score
A good credit score helps underwriters determine how much to lend to the borrower, the repayment period, and interest rate. A high score (ranging from 740 to 800 and higher) makes the borrower look dependable and less risky in the lender's eyes.
Credit scores are based on several factors about the borrower, including their:
- Payment history
- Types of credit
- Credit account
- Credit usage
- New credit line inquiries
Employment status/history
Underwriters also look at the borrower's employment status and/or history. If employed, this evaluation will indicate any gaps in the person's employment history. Frequent job changes—which may be deemed red flags—may result in a request for further explanations or detailed work history.
A self-employed person may be required to have enough savings to cover several months of payments as a buffer.
Credit history
Underwriters also look at the borrower's credit history, reviewing documents like W-2 forms to verify their employment history and status. They'll also look at:
- Bank statements
- Tax statements
- Cashflow
- Assets
- Checking and savings accounts
- Stock ownership
- Personal property
- Real estate
- Late payment history
- Bankruptcies
- Liabilities
- Alimony or child support
Debt-to-income ratio
Underwriters also review the borrower's debt-to-income ratio (DTI), which is a percentage estimate of the minimum monthly debt payments over gross income per month. That way, they can see how well the borrower manages debts each month.
A high percentage shows a higher risk of defaulting on loans. Typically, lenders prefer a DTI of up to 45% or 50% (in some cases) on the borrower's revolving accounts and regular scheduled expenses like car payments, credit cards, or monthly mortgage payments.
Loan-to-value ratio
Underwriters calculate a borrower's loan-to-value (LTV) ratio by dividing the loan amount by the asset value, then multiplying by 100 to get a percentage.
For instance, if a borrower wants to buy a home appraised at $750,000 and the loan is $600,000, the LTV is 80%. The LTV ratio usually drops as the borrower repays the loan, but the higher it is, the riskier the borrower is to the lender.
Additional paperwork
To gain a more comprehensive understanding of a borrower's financial history, underwriters may also require them to provide other pieces of information. For instance, legal documents verifying child support, alimony, or other court-ordered debt may be useful in completing the loan underwriting process.
They can also request for court orders, divorce decrees, letters from friends of the court, or other paperwork that may impact the borrower's overall financial situation as they review their application.
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