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What is Underwriting in Real Estate?

Understanding the Underwriting Process of the Real Estate Industry
Written by
January 19, 2023
/
4
min read

The underwriting process is when a lender assesses the financial status of a potential borrower. In real estate, this is done by examining credit score, income, debt, and the property's value and condition. This method allows the creditor to evaluate the risk of loaning money.

What are the key components of underwriting?

The underwriting process comprises five steps: assessment of creditworthiness, calculating income, determining liabilities, evaluation of financial risk, and setting terms and conditions. An underwriter will take these steps in every loan before the lender finalizes.

Assessment of creditworthiness 

This step entails reviewing the individual or organization's credit history, credit score, and credit reports to determine their ability to repay the loan or meet the terms of an insurance policy. This step also involves estimating the DTI (debt-to-income ratio). 

The credit report is crucial because it informs the lender how able you are to repay the money. A credit score of 620 or higher is required for a conventional loan. Higher credit scores secure better rates because the lender takes on less risk.

The debt-to-income ratio verifies that the potential borrower can handle the financial burden. The ratio is monthly income divided by monthly payments. Lenders prefer to see a debt ratio of less than 50%, or 0.5, to qualify. This is to protect both the lender and the borrower.

Evaluation of income

The underwriter’s job is to ensure potential borrowers can repay the loan with interest. This is critical in the loan process, as it ensures that the borrower can make their payments on time and in full. 

To evaluate the borrower's income, lenders scrutinize their income sources, such as salary, wages, bonuses, commissions, and investments. They also examine the borrower’s credit history, including their credit card payment history, student loans, mortgages, and other debts.

Determining liabilities

This involves reviewing financial documents to assess the borrower's or policyholder's outstanding financial obligations, including mortgages, car loans, and credit card balances.

Requested documents such as W-2s, paystubs, and bank statements will include proof of income. You may need profit/loss sheets, k-1s, tax returns, and balance sheets if you are self-employed. It is best practice to have at least two years of financial documentation.

The underwriter will also confirm the wages align with what you have reported and verify with your employer if applicable.

Assessment of financial risk

Based on the information gathered during the underwriting process, the financier determine the level of risk involved in extending credit. They will also decide the liability in taking on the borrower.

This helps them stipulate whether to approve the loan or insurance policy and, if so, at what terms and conditions.

Setting terms and conditions

Based on the level of commitment, the lender or insurer will set the terms and conditions, including the interest rate or premiums, repayment terms, and covenants or restrictions.

Does underwriting affect the real estate market?

The process of underwriting determines who is equipped to obtain a loan and on what conditions. If underwriting standards are too strict, it can be difficult for potential buyers to qualify for a mortgage, limiting demand for properties and putting downward pressure on prices.

On the other hand, if underwriting standards are too lenient, it can increase the number of risky loans being made, leading to defaults and foreclosures and perhaps destabilizing the real estate market.

The underwriting process is a vital factor when buying and selling of homes. Underwriters examine the property sold and the buyer and establish whether it is a beneficial transaction. 

Benefits of Underwriting

Underwriting provides many benefits through risk assessment, which is why it is a core tool in many industries. These benefits include pricing, loss prevention, consumer protection, and financial stability.

Risk assessment

Underwriting allows insurers to identify the risk associated with providing coverage to a potential policyholder. This helps insurers confirm whether the policyholder is responsible and whether they should offer coverage.

Pricing

 Underwriting helps lenders to determine the appropriate terms for a loan. This is based on the risk level of the potential borrower.

Loss prevention

By identifying risks, underwriters help lenders and individuals prevent losses. Underwriters achieve this through risk assessment, pricing, and using risk management tools and techniques.

Consumer protection

Underwriting helps lenders ensure they provide loans to financially stable individuals and entities, capable of making payments without defaulting or going bankrupt. This protects consumers from fraud and financial loss.

Financial stability

Underwriting helps lenders to manage risk and maintain profits. This is important for the cohesion of the real estate industry as a whole and helps to protect the wealth of both buyers and sellers. 

Risks of Underwriting

Five perils are associated with underwriting: fraud, legal jeopardies, reputation risks, and misjudgments.

Fraud 

The possibility of fraudulent activity during the underwriting process. Borrowers may provide false information to secure better rates. This slights the lender and underwriter and will also result in legal consequences for the borrower.

Legal risks

Underwriting consists of analyzing and gathering personal and financial information. Mishandling or improper protection of these documents puts the lender at legal compromise.

Misjudgments

If an underwriter misjudges the liability of a potential borrower, it can lead to lenders accepting higher-risk clients at lower rates. This increases the likelihood of a creditor losing profits. Misjudgments lead to financial instability. 

Reputation risk

Strict underwriting standards may require attracting new policyholders. Conversely, lenders too lenient may face an increased losses. Ensuring that the underwriters keep faith with proper risk analysis is a challenge for all financiers.

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