April 5, 2017

Loan Process: How the Mortgage Underwriting Process Works

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The loan process for a mortgage is complicated. Understand how the underwriting process works so you can improve your approval odds.

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Make the right decisions when you're about to take out a mortgage by understanding how the underwriting process works.

Obtaining a mortgage requires more than submitting an application. An intricate process goes on behind the scenes. The more you understand about it, the higher your chances of approval. The process begins with the loan application, and from there it goes to loan processing and underwriting. Here we take an in-depth look at the process to give you a better understanding.

First Step: Loan Application

The loan application starts every loan process, no matter the program you choose. This important document lets the lender know your qualifications for a specific program. Understanding the information you must provide can help speed up the process. A few things you must know:

  • The type of loan you desire (for more information on this see our article "The Different Types of Mortgages")
  • The loan amount you need (for more information on figuring this out, see our article "How Much House Can I Afford?")
  • The property address, unless you have not started shopping for a home yet
  • Personal identifying information, including your social security number, birth date, and address
  • The name and address of your employer; the dates you worked there; and the amount of your gross monthly income
  • A detailed breakdown of your income, including any bonuses, commission, rent, or dividends
  • Assets, including all checking or savings accounts; stocks; bonds; retirement accounts; and owned real estate
  • Debts, including every recurring monthly debt reporting to the credit bureaus

This application is used by the lender to start the process. Even if you only want a preapproval initially, the loan application is how you start. For more information on the preapproval process and its importance, read our article "Mortgage Preapproval."

Second Step: Loan Processing and Information Gathering

The second step of the loan process involves the processing department. Your loan processor will let you know the documents needed for your file. Without a complete file, your underwriting process could be delayed. The most common documents needed include:

  • Paystubs covering the last month of employment
  • W-2s for the last 2 years
  • Tax returns for the last 2 years (if you are self-employed or work on commission)
  • Asset statements for the last few months
  • Credit report
  • Appraisal (once you find a property)

The loan processor evaluates these documents before moving you onto the underwriting step. The processor looks for any discrepancies in your documents. They watch for any potential issues, such as a high debt-to-income ratios or delinquent credit histories. These issues could prevent you from securing an approval. Working closely with the processor can speed up the loan approval process.

Third Step: Underwriting

After the processor has the necessary documents, they move your file into underwriting. The underwriter looks through your documents according to two different requirements:

  • The government agency or secondary market for your mortgage program
  • The lender's guidelines

The loan program you apply for determines which method the underwriter uses. For instance, on a conventional loan, the underwriter must follow the Fannie Mae or Freddie Mac guidelines. These are the government enterprises that will purchase the loan on the secondary market. If your loan does not meet their requirements, they will not purchase it.

Some lenders add more requirements onto the Fannie Mae or Freddie Mac requirements, though. This is in an effort to protect themselves from default, since the bank funds the loan. To learn more about the type of loan programs available, read our article "The Different Types of Mortgages."

The underwriter's focus is on your risk level. This is what lenders and the investors care about the most. They look at factors such as:

  • Do you have a history of late payments on any other accounts?
  • Did you file bankruptcy in the past?
  • Do you have any foreclosures in your housing history?
  • Do you have experience with housing payments (mortgage or rent)?
  • How much of your available credit do you have outstanding?
  • Do you pay more than the minimum payment on your revolving debt each month?
  • Do you have many inquiries on your credit report?
  • What is the average age of your open accounts?

Each of these factors plays a role in your riskiness. For example, borrowers with a history of late payments or a bankruptcy pose a major risk to lenders. If you know you have delinquent accounts on your credit report, you need an explanation. The official way to provide an explanation is with a Letter of Explanation (discussed below).

Aside from your risk, the underwriter must evaluate the three C's of underwriting. These are Capacity, Credit, and Collateral.

  • Do you have the Capacity to pay the loan? The underwriter looks over your employment, income, and assets. The more stable your employment and income, the better your chances of approval. Generally, lenders like a 2-year history with the same employer. Your assets also determine your capacity to afford the loan. Having money you can tap that can cover your mortgage if you lose your job is important. Lenders look at your reserves after subtracting the amount of your down payment.

  • Do you have a reputable Credit history? This is what we talked about above. The underwriter evaluates your credit report very carefully. Your payment history plays a role in your risk level. Generally, patterns you have in your credit history repeat themselves in the future. Unless you have a clean credit history, a lender may not want to take a chance on you.

  • Is there adequate Collateral? The property you purchase is the collateral. Without an appraisal, the lender cannot determine the value of the home. The underwriter will look over the appraisal for value as well as the type and condition of the property. Certain types of homes are not eligible for specific loan products. For example, FHA loans have strict rules regarding condos because they're considered a higher-risk investment than single-family homes.

Tip: If you changed jobs within the last 2 years, you may still secure an approval. Lenders prefer job changes remain within the same industry. However, if you changed industries as well, consider the reasons. Do you make more money at your new job? Do you have adequate training for the new position to guarantee success? Lenders look at these situations as favorable in some cases. Just make sure you have adequate proof of the change to make it look favorable.

Special Circumstances

No two loan applications are the same. Sometimes loan applicants have special circumstances. They do not always preclude you from a loan approval. Here is an example:

Tom lost his job 2 years ago. His company closed; it had nothing to do with Tom's wrongdoing. Because of the job loss, Tom could not keep up with his loan payments. The stress of the company closing caused Tom to suffer from some medical conditions as well. Because of this, he could not find another job for 12 months. In that time, he lost his home and almost had to file for bankruptcy. Since then, though, Tom found a higher paying job, re-established his credit, and has a clean rent history for the last 12 months.

On the surface, Tom's situation looks very risky. You see his payment history and assume he is high risk. However, with a proper Letter of Explanation, Tom could provide details on the situation. In a letter signed and dated by Tom, he discusses the circumstances. Along with the letter, Tom provides proof of his job loss, decreased income, and medical conditions. His landlord also provides proof of his timely rent history and a recommendation. Underwriters take all of these details into consideration when underwriting his file.

Types of Approval

Getting through the underwriting process is only half of the battle. You still must understand the type of approval you receive. Very few borrowers receive a clear approval and move straight to the closing. Instead, they receive an approval that requires the satisfaction of certain conditions. Here are the different terms you may hear:

  • Clear to Close. These are the "golden words" in underwriting. When you hear this term, it means you can schedule your closing. There are no more outstanding conditions on your loan. The underwriter puts his stamp of approval on the file.

  • Approved with Conditions. This is a more common approval. You receive this type of approval when the underwriter goes through your file and requests more information. A few examples include large deposits on your asset statements or collections on your credit report. Anything that catches the underwriter's eye as risky will likely trigger the need for more information. Don't worry if you hear your loan is "approved with conditions." It just means the process will take a little longer. The faster you provide the necessary information, the faster you can get that "clear to close."

  • Denied. This term goes without saying. If your loan is flat-out denied, you may have to go back to the drawing board. Your credit may need some improving; debts decreased; or more stable employment. Your loan officer will likely give you a reason for the denial. This gives you the chance to work on it for future approval.

Bottom Line

We understand the loan process can seem overwhelming. Breaking it down into phases can help. Focus on your loan application and provide favorable terms. Preparing yourself ahead of time for the process helps a lot. In our article "How to Buy Your First Home," we help you understand how to best prepare yourself for loan approval.

Take your time when applying for a loan. Make sure you know what you are getting yourself into and that you can afford the loan. The final step in the process is closing - this is when the loan and home become your own. The more you prepare yourself ahead of time, the better off you will be.

More from CreditDonkey:


How Much Money Do You Need to Buy a House


Pre Approval Mortgage


How to Get Approved for a Home Loan

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