What is Underwriting?
This topic is an interesting one in deed, that I believe will be quite beneficial to explore. And the topic is…drum roll please…underwriting. So underwriting in the lending world is basically just assessing the risk of applicants and then approving or denying the loan application.
Underwriters often times get a bad rap for being the bad guys of a financial institution. Why is this? Well mainly because they have to say NO sometimes when the risk vs. reward of a loan application doesn’t balance out accordingly. They also are then legally required to give you, as the loan applicant, the reasoning behind a denial of a loan. As you can imagine, this doesn’t always feel good to hear.
Blame It On The “Bad Guys”
So in order to do their jobs effectively, underwriters do at times need to say no to lending out money. Then they must provide a little bit of tough love regarding the reasoning for why they said no. And since most people need the money they are applying for in regards to a particular reason, this makes it even tougher love because the applicant is often then disappointed or even angry that they are not getting the money they want.
So who gets the wrath then? Well usually the whole thing is easily blamed on the mean old underwriter or banker for squashing a loan applicant’s ever-loving dreams. How dare he or she! They certainly must not understand the gravity of your situation in your humble opinion, right?
I’m not advocating that underwriters get it 100% right 100% of the time either. They are human just like you and I, and underwriting is ultimately a judgment business. So there can be misunderstandings or miscommunication at times, and those instances should be brought back to the underwriter’s attention or escalated up the ladder for a second look.
What also must happen though is a little something called self-accountability from the applicant. And don’t hurt the messenger here! Because I know people don’t like to hear that they had anything at all to do with their loan application being denied or counter-offered. It is much more gratifying to just blame it on the “bad guy” underwriter or banker instead. After all, what do they know anyway?
So I’m acknowledging that sometimes (and I do mean sometimes) the underwriter’s decision may be off balance and need correcting. And if you honestly believe this, you should get clarification and possibly even escalate to another set of eyes and ears. But before you immediately jump to this conclusion, just hold your roll for a second and hear me out here. LOL.
They are legally required to give you reasons for your loan application denial. Even if a financial institution counter offers your application, they must give you the reason. Examples of a counter offer are: Approval for a lesser loan amount, approval on different loan terms than on the original application or approval with collateral on your loan instead of without.
So after the disappointment and possible enragement simmers down, just pause for a moment and reflect. Did you actually listen to the reasons for the denial or counter offer and consider the validity of them? Did you reflect on those reasons before just reacting and possibly going straight toward blame of the lender? Basically…is there truth to the reason(s) given?
Knowledge Is Power
So if you discover there is some validity or truth to the reasoning, that is ok. Because knowledge is power. And today we are going to talk about loan applications and which risk variables on a loan application give financial institutions the most heartache. Then you can go use this information to improve in these areas if need be.
Possessing the ability to borrow money is most definitely a part of a person’s financial arsenal. Let me be clear about that. Remember from the topic on the prior blog and podcast Debt Slayer, not all debt is considered equal and not all debt is inherently bad. Having access to money when you need it (even if you are borrowing and paying back over time) is incredibly important to your overall financial well-being. I think we can all agree on that.
Lending Risk Variables
So below are some of the most important risk variables that financial institutions and underwriting people/systems look at to analyze the overall risk of a loan application before making the decision whether to approve:
Your Credit Report
Sorry but there is no getting around this one. Financial institutions look heavily at your credit report because your credit report provides an in-depth history of how you have (or have not) paid back other financial institutions and people who have lent you money. It also gives lenders a detailed picture of your existing debt load and how active (or inactive) you’ve been with your financial activity.
So the credit report is heavily analyzed to determine what’s going on with your current finances along with what you’ve done in the past financially. Obviously underwriters are going to view more negatively the following items on the credit report: unpaid loans, collections, bankruptcies, delinquencies, and/or any other judgments. These are going to be red flags to a financial institution.
The good news is that you don’t have to have flawless credit to be approved for a loan. But if flags on your credit report go up to an underwriter, they will want to understand in detail what happened before determining whether your loan is a good risk to the organization (aka- their employer who signs their paychecks). Underwriters are paid to analyze risk. So naturally when they see items that throw up flags, they will want to understand thoroughly so they can make the best decision.
Some items are not going to carry the same negative impact as others. For example, an old medical collection may not throw up much of a flag if you have paid all your other lenders. It is commonly understood that the health care world can be hectic and that these expenses are unexpected and can sometimes slip between the cracks. This doesn’t mean I’m advising you not to pay your medical bills! If you can, contact medical providers and they will often work out an easy payment plan for you if need be.
Another thing to be mindful of when it comes to the risk analysis of your credit report is that lenders typically will pay close attention to “alike credit” in relation to your type of loan application. For example if you are applying for a car loan and have had some past payment issues with a credit card, but you’ve always paid your car loans on time; this will give you a higher probability of getting approved for that car loan application.
Read the blog or listen to the podcast Mind Your Credit for detailed information on your credit report, including how to enhance your credit score. This will help you tremendously if you need information or improvement in this area. As a general rule, the better history you have of paying lenders back according to your credit report, the better odds you will have of getting future loans approved. Makes sense right?
I’m sure you’ve all heard of debt ratios by now, but let’s dive into what they mean a little further. There are many kinds of ratios which can be calculated on your loan application depending on what you’re applying for and the specific lender. Some debt ratios calculate ratios to predict the statistical likelihood you will file bankruptcy in the future (based on your existing debt load from your credit report). Other ratios calculate how much a new loan payment is in relation to your overall income, so that the payment is not too high of a percentage.
The most commonly used ratio you’ve probably ran into by now is the debt-to-income ratio or DTI. Put simply, this ratio helps the lender determine if you can afford all of your existing debt plus the new payment on the loan which you are applying to obtain. This ratio is typically calculated based on your financial payments if your loan application were to be approved (so if you are paying off existing debt with the loan appication, the payments wouldn’t be duplicated).
The formula for this calculation is: All your applicable existing payments plus the new payment on the loan application divided into your monthly income. If your DTI is considered to be too high, then you will most likely not be approved for the loan. This is because it was determined that your payments are too high in relation to your monthly income. In other words, you can’t afford the loan.
The normal range for DTI really depends on the lender and the type of loan application, but most financial institutions’ DTI maximum runs in the 43%-50% range. This means your payments can’t take up more than 43-50% of your monthly income. Some financial institutions will go higher, but they will want a good reason to do so.
Even though it’s not fun to hear your DTI is too high to get a loan, please take notice if you are told this. Lenders do not want to set you up for failure! They want you to be able to pay back the loan. So if they believe you are living outside of your means and your payments are too high for your income, please take a good look at this possibility. Read the blog or listen to the podcast Budget Doesn’t Have To Be a B Word for advice on how to balance your budget if need be.
So it goes without saying that lenders want to know you have a source of income available to pay the loan you are applying to get. This is why lenders will examine your current employment situation and your employment history. The more stable you are in this area, the better.
However this doesn’t mean you must work for the same company for a decade. Lenders are more looking for stability of an income stream. For this reason, large lapses of employment or income are frowned upon. If you don’t have the consistency of a steady income stream, a lender can look at other compensating factors to still approve your loan.
One area they can look at is your assets. In other words, do you have money set aside to still be able to pay back the loan? If you don’t have consistent income and don’t have assets to fall back on, this can cause an issue for a lender because there may be concern about your ability to pay back the loan on a monthly basis.
Having a strong credit history to prove you’ve always managed to pay lenders back in the past with your existing income and employment history can also help overcome this concern.
Loan To Value (LTV)
The last main risk variable I’m going to discuss is the existence of collateral on a loan and the corresponding loan-to-value (LTV) of that attached collateral. The formula for calculating LTV is: The loan amount(s) secured by the collateral divided by the determined value of the collateral. If you have no collateral on the loan, then your loan application is considered unsecured and will naturally go through a different approval process because there is no collateral to fall back on if you don’t pay.
If you are applying for a car loan or a mortgage loan for example, these types of loans are secured by collateral of either the car or the piece of property. This means the lender can take the car or property if you don’t pay these types of loans and then sell to get their money back. So collateral basically provides a Plan B for the lender to get their money back.
So the lower the LTV on collateral, the better. This is because the lower the amount you have borrowed against collateral securing a loan, the more likely the lender can sell that collateral down the road if you don’t pay to get their money back.
Lenders are in the business of lending money to then get the money paid back with interest. They honestly don’t want to take your collateral and sell it. But they will, oh yes they will! Wouldn’t you? So when lenders have a good Plan B in place, it naturally only helps your odds of approval.
Strive For Better, But Also Don’t Stress
Since we are discussing ways you can improve your ability to borrow money, I feel the following quote is applicable.
Hellen Keller said the following:
“Be happy with what you have, while working for what you want.”
So if you do need to improve any of the areas which heavily impact your ability to borrow money, it probably won’t be an overnight process. But that is perfectly ok. This quote gracefully reminds us to be grateful for what we have now! Just also start working for what you want to improve. You’ve got this!
Listen to the Mind Your Money Podcast on iTunes Podcast, Spotify and Stitcher apps today!