Mortgage underwriting is the process a

lender A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property ...

uses to determine if the

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

(especially the risk that the borrower will default ) of offering a

mortgage loan A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any p ...

to a particular

borrower A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...

is acceptable and is a part of the larger

mortgage origination In consumer lending, mortgage origination, a specialized subset of loan origination, is the process by which a lender works with a borrower to complete a mortgage transaction, resulting in a mortgage loan. A mortgage loan is a loan in which pro ...

process. Most of the risks and terms that

underwriter Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabilit ...

s consider fall under the five C’s of underwriting:

credit Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt), ...

, capacity, cashflow,

collateral Collateral may refer to: Business and finance * Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan * Marketing collateral, in marketing and sales Arts, entertainment, and media * ''Collate ...

, and character. (This is also known in the UK as the three canons of credit - capacity, collateral, and character.) To help the underwriter assess the quality of the loan, banks and lenders create

guidelines A guideline is a statement by which to determine a course of action. A guideline aims to streamline particular processes according to a set routine or sound practice. Guidelines may be issued by and used by any organization (governmental or pri ...

and even

computer models Computer simulation is the process of mathematical modelling, performed on a computer, which is designed to predict the behaviour of, or the outcome of, a real-world or physical system. The reliability of some mathematical models can be deter ...

that analyze the various aspects of the

mortgage A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...

and provide recommendations regarding the risks involved. However, it is always up to the underwriter to make the final decision on whether to approve or decline a loan.

Risks for the lender

Risks for the lender are of three forms: interest rate risk, default risk, and prepayment risk. There is a risk to the lender that the rate on an

adjustable-rate mortgage A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.Wie ...

may decrease. If this is not matched by correlated decreases in rates on the lender's liabilities, profits will suffer. If a rate on a mortgage contract increases significantly, this is normally favorable to the lender in the absence of correlated increases in rates on liabilities. However, the lender faces the risk that the interest rate increase could be unaffordable to the borrower, forcing the borrower into default, in which case it could be necessary to foreclose on the property (with substantial costs of foreclosure). In addition, the lender faces the risk that the value of the property underlying the mortgage could drop in value to below the outstanding balance on the mortgage; if this event induces the borrower to default due to

moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...

, the lender must not only incur the costs of implementing a foreclosure but also must sell the property at a price that fails to recoup the lender's investment. One additional risk for lenders is prepayment. If market interest rates drop, a borrower could refinance the

fixed-rate mortgage A fixed-rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment amounts and the duration of th ...

, leaving the lender with an amount that now can be invested only at a lower rate of return. This risk can be mitigated by various sorts of prepayment penalties that will make it unprofitable to refinance even if the rates of other lenders decrease.

References

{{Real estate Mortgage Risk analysis Financial risk management Underwriting

Risks for the lender

See also

References