The process of verifying a borrower’s creditworthiness prior to approving a bank loan is known as underwriting. An underwriter is tasked with verifying a borrower’s ability to pay before giving loan approval. Underwriters look at a lot of different things during what can be a lengthy process.
So, what do they look at? Below is a list of the most common factors. Note that there is one exception to all of this: hard money lending. A hard money lender has a different underwriting process. According to Actium Partners out of Salt Lake City, UT, a typical hard money lender has a much less complicated underwriting process compared to banks.
With that said, here are some of the things traditional lenders look at:
1. Credit History and Score
Let us start with credit history and score, given that this is what most of us think about in relation to underwriting. Unlike hard money lenders, banks look at borrower credit histories and scores to get an idea of how they have managed their finances in the past. A low score with a checkered history indicates a borrower may not be the best financial manager. It also suggests a higher risk of default.
Even if approval is given, a low score almost always means a higher interest rate and less favorable terms. This is because interest rates are a tool for protecting the lender’s financial interests. The lower a borrower’s credit score, the higher the interest rate tends to be.
2. Debt-to-Income Ratio
Next up is the borrower’s debt-to-income ratio. This is a ratio that compares the borrower’s current debt load to their current income. Adding additional debt without increasing income increases the borrower’s ratio. The higher the ratio, the less likely a loan will be approved. And just like with credit score, approving a loan with a high debt-to-income ratio almost always results in higher interest rates.
3. Current Income
Lenders also look at a borrower’s current income separate from their debt-to-income ratio. The income will be compared against normal living expenses – like housing and food. For example, let us say you are looking at a borrower attempting to get a residential mortgage.
It is generally accepted that housing costs should not exceed 30% of a borrower’s gross income. If approving the mortgage would push that number above 30%, it is highly unlikely the borrower will get the loan. There are exceptions to the rule, but the chances are not particularly good.
One last thing to note about current income is its relation to a borrower’s length of employment. A borrower with stable income and the same job for several years is less of a risk than someone who changes jobs every few months. Even with enough income, a history of frequent job changes is a red flag for banks.
4. Other Assets
Lenders typically ask borrowers about their other assets. They want to know about things like real estate, securities, etc. before making approval decisions. The existence of high value assets might be enough to gain approval even if a borrower’s credit score isn’t as high as the lender would like. And that is just one example. The point is that tangible assets are viewed favorably by lenders because they can be liquidated if necessary.
Lenders look at other things as well, including the purpose for the loan and the value of whatever is being financed. Needless to say that underwriters have a lot to do. That is one of the reasons it tends to take so long to close on a residential mortgage. Underwriting is a lengthy process.