How Lenders Assess You(r Risk Level)
There are many factors considered by a mortgage lender when you apply for a mortgage, each of these affect the interest rate, mortgage product type, and ultimately the amount for which you qualify and are ultimately granted. The process of this review is known as underwriting.
Why Do Lenders Underwrite?
Mortgage lenders are in the business of making money by lending money and earning interest throughout the lifetime of the loan (in addition to the principal amount paid back to the lender). To do this, lenders must understand their risk to ensure that the borrower has the ability to pay back the loan. To do this, lenders review the Three C’s:
Credit is a determination of the borrowers ability to pay back the loan based on the borrower’s history with debt. To confirm this, lenders will run a credit report which returns, among other things, a FICO score that whittles down the borrower’s “creditworthiness” into a single number (the higher the better).
Lenders often set thresholds for certain credit scores that can dictate the willingness to lend and interest rate. For riskier borrowers, lenders will often charge a higher interest rate to offset the risk of non-payment or default (when the borrower is defunct and unable to repay the loan).
Moving from past to present, capacity requires the lender consider whether or not the borrow can afford the amount leant. This is done by analyzing the borrowers income (both consistency and amount), other existing debts (like student or auto loans), and to a lesser degree the amount of cash available on hand and expected budget.
Collateral represents the assets that ‘back-up’ the loan, meaning if the borrower is unable to pay back the loan, the lender will instead take into possession the collateral as an alternative source of repayment. When buying a home, this means the house. If the borrower is unable to make mortgage payments, the bank may be able to take the home from the homeowner via a foreclosure.
This is why a home appraisal is an important part of the underwriting process. Lenders, unsurprisingly, are unwilling to lend more money than a home is worth, because immediately the collateral value is worth less than the loan.
Lenders consider whether or not the borrower will be treating the home as their primary residence (‘Owner Occupied’) or as a rental/investment property. Borrowers who are buying a home as their primary residence are afforded more mortgage options given there is inherently less risk than an unoccupied or rental property. A key difference for borrowers is for rental/investment properties, lenders will often require as much as 20-25% down payment and additional fees.
Similar to the home use, the property type matters. Single family homes as just as they sound - your standard family home. Condos (simplex, duplex, etc) are those with multiple units and managed by an association. These are, given the property is managed and lived in, and therefore affected, by more than one owner, considered more risky by lenders and can often mean a slightly higher interest rate than the same loan for a single family home. Other common home types include Townhomes. These are communities of similar homes, often referred to as Planned Urban Development (PUD) in lender-speak. While similar to a single family home where the owner purchases and owns the entire unit, they are managed as an association and carry similar treatment to condos. The difference is the owner is responsible for the exterior of the home as well, unlike a condo (which falls on the responsibility of the association, or collective of condo-owners).
Quick Note on Home Owners Associations
Home Owners Associations (HOAs) are the collective effort by the owners of Condos, Townhomes, and subdivision dwellers to manage the communal areas and resources of the complex. Unit owners often pay monthly HOA dues into a common fund that is used for common area maintenance, building related utilities (common area electricity, for example), and insurance, among others.
Condos are most commonly associated with HOAs given the unit owners are responsible (meaning they pay for anything related to) the interior, while the unit owners collectively are responsible for the upkeep and maintenance of the exterior, such as the roof, parking lot, and shared areas like stairwells. The rules and responsibilities of the HOAs are defined in the operating agreement and bylaws of the association and can be managed by the unit owners or outsourced to property management companies.
When underwriting and considering making an offer on a condo or HOA-associated property, lenders (and buyers) will consider the amount of money the HOA has in reserves, meaning the amount in the bank account. HOAs with little cash are more risky given that if a large expenses is needed, unit owners will need to pay out-of-pocket. On the other hand, HOAs with healthy reserves are in a better position to handle such events.