Taking out a mortgage to buy a house can be stressful time for potential buyers. The idea of owing twenty to thirty years of payments and the idea of buying a house for hundreds of thousands of dollars can be daunting. However, for the lending institution such as a bank the choice to extend a mortgage is simply another business decision. Like any business decision, extending a mortgage is a question of risk, return, and opportunity cost.
The term underwriting derives from a nineteenth-century English insurance institution called Lloyd’s of London. This institution would absorb some of the risk of sea voyages by insuring that cargo would reach its destination unharmed. In the event of the ship sinking, the underwriter, bearing some of the risk and having been paid a premium to do so, would pay for the losses. Today, mortgage underwriters are interested in two things: Can the buyer repay the mortgage and what is the value of the property should the buyer be unable to pay back the mortgage? Knowing these two concerns of the underwriter, a potential buyer can better prepare for the underwriting process.
Three Parties in a Mortgage Transaction
From a neutral position, there are three main parties associated with the buying of property. The seller initiates the process by putting a house up for sale him/herself or contracting with a real estate broker to attract potential buyers. The seller is not so much interested in where the money comes from as long as it is secured. Essentially, whether the buyer pays cash for the property or borrows the money from a lending institution, the money is just as green.
Unless unusually wealthy, most buyers take out a mortgage to pay for property. The mortgage, like any other debt, is a promise to pay a set amount each month over the course of twenty to thirty years (sometimes longer or shorter). However, unlike other debt, mortgages are highly regulated to avoid people getting too far over their heads. An unfair mortgage agreement could spell disaster for a borrower since the agreement typically lasts several decades.
The third major party in the mortgage process is the mortgage underwriter, the party responsible for the lending of the money and the party bearing the risk of non-payment. Keep in mind that if the buyer is unable to pay back the mortgage, the lender cannot ask the seller to return the money. Once the money is in the hands of the seller, it is his/hers forever. Any attempt to recoup losses from a defaulted mortgage agreement must come either from the buyer or in the value of the property itself.
The Mortgage Underwriters Role in Buying a House
A mortgage underwriter is the party bearing most of the risk in the buying of property. As in any business, the decision to invest (lend) money is a question of risk, return, and opportunity cost. Lending institutions do not have unlimited funds to lend to debtors. The decision to lend to one borrower in lieu of lending to another represents an opportunity cost. If one borrower is extended a loan instead of another, it is probably because the first borrower was a better risk. Since choosing to do one thing precludes the ability to choose another, it is understandable that the lending institution will choose the least risky alternative first.
Mortgage underwriters assess two main ingredients in the mortgage process. First, they assess the riskiness of the borrower. They ask questions such as will the borrower be able to pay back this loan? What evidence do we have that the borrower will be able to pay back the loan? Is there anything in the near or distant future (such as the age of borrower) that will hinder his/her ability to pay back this loan? Underwriters answer these questions by looking to the loan records of the borrower. Aspects such as credit scores, payment of large ticket item loans, job security, and the marketability of the borrower should the borrower lose his/her job are all things that mortgage underwriters look for when you fill out a mortgage application. Here, borrowers must be sure to look good “on paper” so that they are perceived as a good risk for the lender.
The second aspect mortgage underwriters look to is the value of the property being purchased. Should the borrower be unable to repay the mortgage, the lender may be able to recoup its losses in the equity of the property. Equity means nothing more than value; is the value of the property high enough to cover the lender’s losses? The mortgage underwriter typically assesses property value independently so it obtains a fair and objective value. One way to assess the risk of a mortgage loan is with the loan to value ratio. This ratio calculates the loan as a percentage of the property value. The lower the ratio, the lower the risk. Borrowers with a 100% loan to value ratio are the riskiest to mortgage underwriters so borrowers should avoid financing the entire purchase of property. Again, looking good on paper is the best chance a borrower has of being extended a mortgage.
The mortgage process is a complicated one but the overall question of whether to lend money to a potential property buyer is one of risk. Mortgage underwriters look to the past (credit scores, past credit payouts, etc.) and to the future (value of the property in the case of default) to assess the riskiness of a mortgage loan. By tending to these two aspects of mortgage assessment from a lender’s point of view, potential buyers can better leverage their chances of being approved for a mortgage.