What Is Underwriting?
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How Underwriting Works
Underwriting is an important part of the financial sector, particularly in insurance. It measures the risk a deal brings to the business before assuming and accepting that risk. In other words, underwriting calculates the amount of profit versus risk in a deal.
Underwriting is facilitated by an underwriter, a person in charge of assessing insurance or loan applicants and deciding whether the amount of risk they present is acceptable. An underwriter may be an employee of the lender or insurance company or it could be a third-party organization contracted by that company.
An underwriter’s role is to paint an accurate picture of the risk that the lender, insurer, or investor is going to absorb. If the odds of making a profit outweigh the risk and the attributes of the deal are consistent with the organization’s model, they can approve the transaction. A loan is never fully approved (even if it was pre-approved) until the underwriter confirms their confidence that the borrower can fully repay the loan. To do this, the underwriter must inspect the borrower’s financial capacity and other circumstances of the loan, property, or insurance application.
Why Is Underwriting Important?
Without an underwriter, businesses may incur losses due to undetected risk. All transactions have risks, but the underwriter ensures that the benefits to be gained by going through a transaction or closing a deal will outweigh the risks. In short, underwriters perform an essential function—to decide whether it is advantageous for an organization to take a chance on certain risks.
Underwriting also helps regulate market prices, protecting the interests of all parties in a transaction. An accurate risk assessment by setting a benchmark or underwriting guidelines across industries allows markets to match costs versus risk.
Automated vs. Manual Underwriting
Most of the time, lenders use computer software to quickly analyze the risk they are taking on for a specific loan application. This is called automated underwriting, where the software analyzes a borrower’s financial status from only a few inputs, such as the name of the borrower and their Social Security number.
While automated underwriting is far faster than manual underwriting, the computer does not always get the full picture of an individual’s finances, such as for those with fluctuating incomes or people without debt. In this case, manual underwriting may be used to get a more accurate sense of the applicant, though it takes much longer.
Where Is Underwriting Used?
Underwriting is used in different fields in the financial sector.
- Insurance. Underwriting is the foundation of the insurance industry. For example, health insurance underwriters calculate the suitable premiums for applicants based on their current health condition, existing illnesses, and potential health risks based on the client’s lifestyle. The same goes for life insurance, where underwriters assess the same factors, including employment risks.
- Lending. For individual loan applicants, underwriters assess if the applicant can repay the loan based on certain factors, including their credit score. For businesses, underwriters assess the business’s debt service coverage ratio (DSCR), income, market performance, competition, and market trends related to the business.
- Real estate. Similar to a loan, underwriting involves evaluating the property that a real estate investor is applying a loan for. It involves not only looking at the property in question but also at the financial credibility of the investor themselves. Some underwriters even look if the property can secure the loan as collateral and if the property’s value does not exceed the amount of the loan being requested. However, some investors even underwrite a deal themselves (with the aid of a financial advisor), especially in a seller-financed transaction.
- Stock exchange. Underwriting allows investors and sellers to trade and buy stocks at an appropriate price. Initial public offerings (IPOs) are also underwritten to aid investment banks and other investors to see if it makes financial sense to buy public shares.
How Does the Underwriting Process in Real Estate Work?
Real estate investors generally approach real estate underwriting in two ways. The first is to gauge the viability of the deal, and the second and more technical is the actual process by which lenders assess risk. Mortgage underwriters usually follow the Fannie Mae and Freddie Mac underwriting guidelines, which makes their loans “conforming.”
In real estate, underwriting starts as soon as a lender receives an application for a loan (such as for a mortgage application) or when the investor underwrites their own potential transaction and delivers their assessment to the lender. This is a required process for many lenders before a loan is made. Many lenders require different documents, such as the borrower’s credit report, identification, and pro forma estimates; some lenders may even ask for floor plans or parcel maps, including the investment property’s proximity to flood zones, road access, or environmental risks.
As mentioned above, a real estate investor may also underwrite a deal themselves. Note that this is not a way to get approved for a loan but only as an additional layer of assessing their own risk in a potential deal. Many investors use deal analyzer software to scrutinize the borrower’s creditworthiness and the projected return on investment of the property. A third party, such as a financial advisor, may review the accuracy of this underwriting process, which can give the investor a way to plan for risks and outcomes.
Typically, underwriting may take from a few days to weeks, depending on whether it was automated or manually done.
Underwriting in Seller Financing
One more way an investor can underwrite a deal themselves is when they choose to utilize seller financing.
Seller financing, or owner financing, is a type of financing where a seller essentially extends a loan to a buyer of the property. The seller does not typically transfer money to the buyer; instead, the buyer will agree to pay the seller regular monthly installment payments, depending on the terms of the financing agreement. It works much like traditional financing, but instead of repaying a bank loan, the borrower repays the seller.
Naturally, as the seller somewhat assumes the lender’s role, they may have to underwrite the deal on their own. Many sellers are apprehensive about underwriting this type of financing because of the risk of default, but there are various ways to mitigate the risk. For example, the seller can insist on down payment and/or a loan application form. The seller can even include a clause on foreclosing on the property.
Note that the Dodd-Frank Act of 2014 placed some restrictions on seller financing. One of these is using a licensed mortgage loan originator (LMLO) to underwrite and make loans for borrowers who will use the property as their primary residence. Some exceptions apply, such as if the property is vacant land or if the seller wants to use it as an investment vehicle (e.g., rental).
In such cases, a third-party LMLO or a license is not needed; the seller can underwrite the loans themselves.
What Are Underwriting Guidelines?
There are different ways lenders and insurers underwrite deals, but some standards act as guidelines for a more consistent approval process. For example, conventional mortgage loans are approved using the Fannie Mae and Freddie Mac underwriting guidelines.
Some of these guidelines are described below; note that these are not exhaustive.
|Down payment amount||3% of the loan amount (for primary residence)|
|Debt-to-income ratio||No more than 45%|
|Income||Employed for at least two years with stable income|
|Title||No clouds on the title|
|Property types||Single-family, multifamily, condominiums, co-ops, planned unit developments, manufactured homes with a permanent foundation|
|Occupancy types||Owner-occupied, vacation homes, investment|
|Mortgage insurance||Required for mortgages with less than 20% down payment|
Freddie Mac simplifies this further with the “Three C’s of Underwriting”: credit reputation (score and report), capacity (income and capability to repay), and collateral (the value of the property).
For businesses and other investments, other factors may apply. However, one of the most important is the DSCR, which tells the underwriter if the projected income from the investment is sufficient to repay the loan. A DSCR of at least 1.2 is required, which means that for every $1 of debt, the investment must earn $1.20.
Other requirements include:
- Loan-to-value ratio: 75% to 80%.
- Creditworthiness: The financial status of the principal borrower.
- Property appraisal: Includes location, accessibility, property age, local factors, and appearance. Fair market values will also be considered.
Note that in commercial real estate or in real estate investments, lenders tend to take a more conservative position. Some loan applications are denied not because the borrower has a bad credit history or they fail to meet the underwriting requirements. This may be so because the lender’s portfolio is saturated with the borrower’s investment type or that particular investment type has too many delinquencies (or both).
Underwriting is one of the fundamental functions in finance, where an organization (usually a lender or an insurer) takes on the risk of lending to a borrower or insuring an investment. The underwriting process calculates how much potential profit the organization can make against the risk of lending or insuring the deal.
Underwriting is important for many reasons. More importantly, it allows the market to set a benchmark on how much a certain level of risk costs. Because of its nature, underwriting is used in many sectors in finance, including insurance and real estate.
In real estate, however, lenders tend to look at residential and commercial real estate differently, mostly due to the size of the loan and the risk they are willing to absorb. This is why some investors and property sellers use seller financing, which allows them to underwrite a deal themselves (save for a few exceptions). Otherwise, mortgage underwriters follow a set of guidelines, such as Fannie Mae’s, when approving loans.
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