The business of money lending naturally includes a lot of risk for lenders. If the borrower somehow becomes unable to pay back their debt, the lender has potentially not only lost their investment, but also the interest they would have earned.
Therefore, it is in the lenders best interest to ensure that the people they are giving loans to are likely to pay them back on time and with the agreed upon interest – to make sure that the risk they are taking is within acceptable standards. This vetting process is called loan underwriting.
What Factors Are Considered in Loan Underwriting?
Underwriters consider many factors when assessing a potential borrower, and each can be weighed independently of the others. This means that if one category is excellent, it can outweigh another that may be lacking, and vice versa.
All the factors can all be sorted into the following three categories:
1) Capacity to Repay
One of the first things an underwriter needs to assess is your capacity to repay the loan and interest. This wholistic assessment is based on the borrower’s employment status, income, current debts, and any other assets they may have.
When it comes to evaluating employment status, loan underwriters are mostly looking at the last two years of employment history, and whether the borrower is self-employed or works for another entity. A borrower who is self-employed carries a greater risk to the lender, so they will want to see proof that the borrower can earn a stable amount of income.
In assessing income, the lenders will be looking at the ratio between the borrower’s income and their expenses. They will usually consider the loan too high risk if the borrower’s income-to-debt ratio exceeds 43%. In other words, lenders prefer a borrower’s regular expenses not to exceed more than 43% of their regular income.
2) Collateral Assets
Collateral assets are things that the borrower owns whose value can be used to ensure payment of the loan. For example, in the case of a mortgage, the property itself becomes the collateral; if the borrower defaults in their payments, the bank will take control of the property.
A loan will be at a lower risk to lenders if the borrower has good collateral. Solid collateral assets can also help offset other factors, like a less than desirable employment history.
3) Credit History
All lenders will assess a potential borrower’s credit history before making any decisions. Credit history includes current debts as well as a record of how they have handled payments in the past. Loan underwriters use credit reports from either Experian, TransUnion, or Equifax. They take into account more than just the credit score.
Although the overall credit score is important, lenders prefer to see a strong and varied credit history. A borrower who has a history of making on time payments for various credit cards or other loans – car loans, student loans, etc. – will pose a lower risk to the lender than someone who has a limited history or has defaulted on payments in the past.