underwriting is the process a lender uses to determine if the risk
(especially the risk that the borrower will default) of offering a mortgage
loan to a particular borrower is acceptable. Most of the risks and terms
that underwriters consider fall under the three C’s of underwriting: credit,
capacity and collateral.
To help the underwriter assess the quality of the loan, banks and lenders
create guidelines and even computer models that analyze the various aspects
of the mortgage and provide recommendations regarding the risks involved.
However, it is always up to the underwriter to make the final decision on
whether to approve or decline a loan.
There are two types of risk
facing a borrower in a residential mortgage. The first one concerns the size
of the cash flow to service the mortgage and the other concerns the size of
the balance owing on the mortgage. Respectively related with those two risks
are the concepts of liquidity and net worth.
risk occurs when a borrower is required to pay higher amounts than what he
currently can afford to pay in a mortgage. This can happen for various
reasons. For example, option mortgages popular at the crux of the financial
crisis, offered low teaser rates, which enticed borrowers, but then,
according to contract, reset to higher interest rates, hence higher mortgage
payments, which put many financially pressed homebuyers behind with their
Depending on a mortgage contract, negative liquidity scenarios can
eventually cause default on the mortgage, and foreclosure on the lien
property, or, in other cases a "workout" with the lender that will allow the
borrower, often with some penalties, to come up with make up payments later
Even if a payment growth does not trigger a default or insolvency, it is
still worthy to the borrower to know if they could be required by the
mortgage they undertake to pay an amount that will squeeze out of the
budget many other important necessity expenditures. For these reasons,
clearly, it is important to know how big a mortgage payment can
potentially get and compare with borrower's income.
The other type of risk involves a significant increase (or minimal
decrease) of the size of the balance owing on the mortgage over time. This
again can happen for various reasons, the major one of which is again an
increase of the interest rate of an adjustable-rate mortgage. A spike in
the interest rate, combined with a capped mortgage payment (which can also
appear when interest rate vs. payment rate are different) can lead to
negative amortization or a reduced loan principal repayment, which, when
accumulated over time, would support a very high level of outstanding
principal. The level of the loan balance has a significance when a
borrower is required (or has decided for various reasons) to move out of
the property, e.g. due to a job relocation, i.e. when he needs to sell the
property that could had potentially moved in price under its associated
loan amount. This situation is colloquially known as "underwater
Even if a the loan amount does not increase more than a property value,
the reduced difference of the two would mean a lesser in-pocket cash flow
for the borrower/seller at the time of the sale of the property. This,
although on a lesser scale, is also an ostensible risk.