As published in Scotsman Guide's Residential Edition, July 2011.
Although there is a diverse palette of risk, credit risk is the most important concept for mortgage brokers and originators to internalize. By having a solid grasp of credit risk and the associated underwriting, you can avoid common pitfalls and ensure smooth closings. To do so, you must focus on the five C’s: credit, capital, capacity, collateral and compliance.
1. Credit: In the past decade, originators, underwriters and automated underwriting systems relied on FICO scores as the primary determinant of creditworthiness. Now, however, it is important to understand that a score, on its own, no longer holds the same weight. Credit depth, responsible usage and recovery from derogatory issues have started to impact underwriting decisions in a return to common-sense lending.
2. Capital: Once an afterthought, cash to close and reserves are no longer just compensating factors. Verifying funds is now necessary, albeit arduous. Explaining large deposits, verifying liquidity and identifying insufficient funds or late payments have become standard steps when reviewing bank statements. Additionally, the use of downpayment assistance, seller-paid closing costs or gift funds can increase scrutiny of the loan file. Regardless of the intended use, simply glancing at the ending balance is not an option.
3. Capacity: The implementation of the Dodd-Frank Act along with the Federal Reserve Board’s definition of “ability to repay” likely will do away with stated-income loans for the foreseeable future. Therefore, it is a good time to get back to basics and to understand how to calculate income. Whether digesting a full set of tax returns from a self-employed borrower or attempting to ascertain whether you can use income from a part-time seasonal job, there is no such thing as a cookie-cutter loan. You must master your craft when it comes to analyzing income, because debt-to-income ratios are taking center stage again.
4. Collateral: Declining home values put increasing pressure on Realtors, appraisers and underwriters alike. On purchase loans, there is a real possibility that the home’s appraised value will be less than the purchase price. On refinance loans, there is a high probability that the loan-to-value ratio will be significantly greater than the borrower’s estimate. Understanding the guidelines set forth in the Uniform Standards of Professional Appraisal Practice can go a long way toward preventing stressful situations by ensuring that proper expectations are set from the start. By using the increased availability of public data, originators can predict and explain appraised values better than before.
5. Compliance: The Consumer Financial Protection Bureau is expected to hit the ground running as a regulatory force and will be looking to crack down on noncompliant companies and originators. Therefore, originators must be mindful that their Nationwide Mortgage Licensing System identification number will be attached to every file they originate. Also, whether caused by newer rules like the Mortgage Disclosure Improvement Act and appraiser-independence requirements or old standards like the Real Estate Settlement Procedures Act and the Truth in Lending Act, compliance issues can slow the pace of the loan process dramatically. By understanding compliance guidelines, originators not only stay on the good side of regulators, but also ensure a smooth process for their borrowers.
Credit risk is neither glamorous nor exciting, but its impact is paramount to an originator’s success. Use an exhaustive five C’s checklist when originating a new file. By taking a proactive approach to assessing credit risk, originators can communicate potential issues to all parties involved much sooner in the process.
Scott M. Cole is president and founder of Clearwater Mortgage, a nationally recognized lender based in Minnesota. With a background as a floor trader at the Chicago Board Options Exchange and a degree in economics from Northwestern University, he provides forward-thinking market insight.
Contact him at (888) 502-5327 or firstname.lastname@example.org. To learn more about Clearwater Mortgage, visit www.TheAnswerIsClear.com.