A brief outline
Lenders and investors have something in common when it comes to real estate investing, and that is wanting the most successful investment deal and loan combination. Here’s where underwriting comes in, it helps both lenders and investors determine whether a loan should be approved or not. This depends on whether the investment property is a good deal, and how likely the investor is to keep up with loan repayments.
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If you’re just entering the real estate industry as an investor, you may have heard the term ‘underwriting’, but do you know what it means? Real estate transactions have many variables and this means that something that may look like a good deal now, could turn into a liability later on. Real estate transactions are impacted by various factors such as housing market fluctuations, new technology and changes to the rules and regulations. As such, they can be risky so it’s vital for investors to understand how each moving part works.
Underwriting is one of the least understood concepts in real estate but it is one of the most important to get to grips with, particularly for investors. It impacts the chances of a deal being approved for a loan or not, by figuring out if it’s likely to be successful. To help you, we’re going to answer the question, what is underwriting in real estate?
What does underwriting mean in real estate?
When it comes to real estate, underwriting refers to the process that lenders will take to review a loan application and decide how risky the deal is. The idea is that the underwriting process will help both the lender and the investor to determine whether a deal is likely to be successful or not. It involves analysing the investor’s financial situation and the value of the property that they’re looking at, to make the decision.
An underwriter is the person to conduct the review and, while the process is similar to loan pre-approval, an underwriter requires more in-depth information to determine the potential risk of a deal accurately. In a nutshell, underwriting is all about risk evaluation for lenders.
How real estate underwriting works
The underwriting process can be done within a few days, or it can take several weeks, depending on the complexity of the transaction and how fast the borrower hands over the necessary information. The underwriter is ultimately trying to determine if the borrow will be able to meet their financial obligation with the mortgage payments, and whether the property is worth the loan amount so that the lender knows what position they’d be in, should the borrower default on their payments.
What are the stages of underwriting?
To determine whether a lender should proceed with a loan to a borrower, the underwriting process can be broken up into the following steps:
Step 1: Application
Applying for a loan is the first step on your journey towards getting approved for a mortgage or loan. You’ll need pre-approval for a certain amount and this involves reviewing your financial information, such as your income and debt.
Step 2: Verification
In this step, your financial documents will be verified. Which includes your income and assets, by looking at your tax returns, bank account statements, retirement savings, investment accounts, life insurance policies and anything else to support this. If you’re pre-approved, the lender will give you a pre-approval or proof of funds letter that you can use to show that you’re a serious buyer.
Step 3: Appraisal
The house that you’re interested in buying will get appraised by a professional appraiser, so that the underwriter and lender can determine if the house is accurately priced. The property’s condition is taken into account, along with comparable properties in the area, to determine if it’s worth the price the investor is going to be paying for it.
Step 4: Title search
In this stage, the lender will arrange a title search, which means that history of the property will be checked to see if there are any outstanding liens, unpaid taxes or legal issues with the house. Title companies will then issue an insurance policy that verifies the accuracy of their research.
Step 5: Decision
Now the underwriter will make a decision about the loan and property. The options are; approved, denied or suspended. If it’s approved, then you can move forward with the loan and the purchase of the property. If it’s denied, then you will not be able to get a loan and you can ask the lender for more details so that you can figure out how to get approved next time. If it’s suspended, this means that the underwriter will need more information before they can complete the process, so you’ll need to supply them with what they need.
What are the key factors considered in the underwriting process?
During the underwriting process there are 4 main factors that the underwriter will consider in the review:
- Income: The underwriter will need to know that you can afford to pay the mortgage every month. So, you’ll need to supply two of your most recent bank statements, your W-2’s from the previous 2 years and your two most recent pay stubs. Bear in mind that the underwriter will be verifying your employment and your income.
- Appraisal: This is a necessity when you’re buying a property, so that you and the lender both know what the house is worth, when the appraised value has been calculated. A professional appraiser will conduct the appraisal and assign a value to the property which the underwriter uses to compare with the mortgage amount you’re applying for.
- Assets: The greater the value of your assets, the better. An underwriter is looking to see what assets you have in case you default on your mortgage payments and need to find money. Things like your savings account, stocks and any personal property fall under this category and are something the underwriter will take into account.
- Credit: Your credit score is one of the most important factors in this process, because it shows the likelihood of you paying back the mortgage and not defaulting, based on your previous lending history. The score that you’ll need depends on the mortgage amount that you’re applying for.
According to Fannie Mae’s underwriting guidelines, for a single-family home that will serve as a primary residence, a lender would require:
- Maximum Loan-To-Value (LTV) ratio of 97%
- Credit score of 640 or higher
- Maximum Debt-To-Income (DTI) ratio of 36%
What are the 3 C's of underwriting?
When an underwriter is making their decision, they will collect all the necessary documents. The underwriter will then categorize their findings under 3 groups known as the 3 C’s of underwriting.
Credit
Under this category, the underwriter is looking to see how well you’ve been paying off your credit and whether there are any red flags about your ability to pay off the loan. The underwriter will collect the following information:
- Your credit score and credit report from the national credit reporting agencies
- Any foreclosures, judgments or liens
- Any new credit that you have applied for in the last 12 months
- Your credit accounts: type, age, usage etc
- Any mortgage delinquencies you may have
Capacity
This is where the underwriter compares your income to your recurring debt, to figure out if you’ll be able to pay off the new loan. Here they will use the Debt-To-Income ratio, and they’ll take into account whether you’re self-employed, what your cash reserves look like, what the loan characteristics are and what the purpose of the loan is.
Collateral
In this stage, the lender is looking to make sure that if you default on your loan, they won’t lose out. They’ll use the appraisal to verify the home’s value, and from there the underwriter can determine the Loan-To-Value ratio. The property type, property use and borrower’s total equity or down payment will come into play as well.
What are red flags for underwriters?
An underwriter may deny a loan if they determine that the borrower cannot uphold the financial obligations of the mortgage, or if the home isn’t worth the loan amount being applied for. Some red flags for underwriters would be:
A borrower who has recently taken on new debt.
The amount of debt you have impacts your ability to pay off a new mortgage, and any new debt is likely to be a red flag for underwriters as this increases the chances of you defaulting on your loan, should you over commit yourself to debt.
A borrower who has recently lost their job.
This is one of the biggest red flags for underwriters because the loss of your job would mean that you’re highly likely to default on your loan unless you get a job within a short period of time, and this cannot be predicted.
The house is worth less than the price it’s being sold for.
This can come to light after the home appraisal and could spell the beginning of the end for a borrower if there are problems with the house. The reason is that if you were to default on your mortgage and the lender had to repossess the house, they wouldn’t be able to recoup the amount they had lent.
What happens after the underwriting process is complete?
After the process is complete and a decision has been made, you can act accordingly. If your loan is approved, you can continue on the process of closing the loan. The next steps are as follows.
- The lender will go through all your documents one more time to make sure that everything is correct.
- The lender will pull your credit record again and double-check your employment and income.
- You will receive your closing documents to review and sign, which usually happens 3 days before closing.
- Then it’s time to close, and you’ll pay your closing costs and sign the final documents.
Depending on the lender, you may receive the funding immediately, or it may a few days for them to review the final signed documents. Either way, you’re at the finish line of your loan application.
The bottom line
Now that you understand the underwriting process, this should stand you in better stead to getting approved for a loan and being able to begin or continue your real estate investing journey. Remember to review your finances beforehand, and make sure that you’re able to make the monthly repayments, respond quickly to any requests from the underwriter and gather the documents that you may need ahead of time. This will help speed up the process and make it a smoother ride towards getting approval.