The current housing market continues to battle low affordability, elevated home prices and tight inventory, creating a challenging environment for both mortgage borrowers and lenders. As the landscape of residential mortgage lending evolves, originators are adapting to the needs and expectations of today’s borrowers by embracing technology and leveraging creative underwriting techniques.
“Twenty-three percent of recent mortgage shoppers cite a guarantee of loan approval as a top factor when choosing a lender.”
In the current climate, an assurance of loan approval is almost as important to consumers as a competitive interest rate. Twenty-three percent of recent mortgage shoppers cite a guarantee of loan approval as a top factor when choosing a lender, according to a McKinsey & Company report.
To meet this expectation, originators are moving past the standard prequalification practice and instead issuing guaranteed approvals early in the mortgage process. Rather than relying on borrower-provided information, lenders are leveraging third-party sources and internal bank records to collect data on income, assets, credit scores and debt and then crafting mortgage offers to qualified borrowers.
This move enables lenders to assess risk much earlier and provide conditional approvals contingent on final documentation — such as title, appraisal and insurance. This sets their offering apart from the standard preapproval.
Payment history
While using alternative data in underwriting is not new, its adoption is becoming more mainstream. Whether to supplement traditional credit or serve in its absence, more lenders are turning to information not typically found in credit files — such as rent and utility payment histories and cashflow data — to assess borrowers’ creditworthiness.
Advocates of the use of alternative data state that it enhances a lender’s risk assessment and provides a more holistic view of a borrower’s ability to make a mortgage payment. It also expands homeownership to qualified credit-invisible consumers and borrowers in underserved communities. A 2022 report from the Urban Institute about the use of alternative data in underwriting showed two emerging practices: incorporating alternative data into credit scoring models and supplementing traditional credit scores with alternative data.
The Federal Housing Finance Agency (FHFA) has already approved Fannie Mae’s and Freddie Mac’s transitions to new credit score models, FICO 10T and VantageScore 4.0, which will incorporate rental, utility and telecom payment histories when available. The complete transition is planned to occur in the fourth quarter of 2025.
In the meantime, lenders are using enhanced automated underwriting capabilities, third-party sources and consumer-permissioned data to access alternative data. According to Nova Credit, 59% of lenders currently use a form of alternative data in their underwriting process.
Nontraditional income
With the rise and prevalence of the gig economy and work-from-home jobs in recent years, lenders are more accepting of nontraditional income streams, including freelance jobs, self-employment and remote work. This is evident not only in the number of nonqualified mortgage lenders that have reemerged in the market but also in how traditional lenders are accessing employment data.
Lenders are moving past reliance on paper-based processes and consumer-provided documents, which slows the underwriting process and limits mortgage access to borrowers with traditional income sources. Instead, lenders are leveraging automated income assessment tools, third-party sources and public records. By improving the process of accepting and assessing various income sources, lenders can reach a greater number of qualified borrowers.
Unconventional data
In an attempt to streamline the mortgage process and in light of the widening acceptance of alternative credit data, many lenders are naturally adapting their methods and sources for retrieving information. Some banks and nonbank lenders are improving in-house capabilities with modernized proprietary platforms, as well as artificial intelligence-powered property valuations and document processing.
Others are turning to various third-party technologies and data providers throughout the application and underwriting processes. In addition to rental and utility payment histories, Experian research shows lenders are increasingly using the following sources:
- Alternative financial services data. Information on small-dollar installment loans, single payment loans, point-of-sale financing, auto title loans and rent-to-own agreements.
- Consumer permission data. Transactional information from a consumer’s financial accounts to assess income, assets and cash flow.
- Public records. Local and state public records providing information on a consumer’s professional licenses, property deeds and other data.
- Buy now, pay later. With increased usage of this payment method, assessing a consumer’s payment history and upcoming transactions can provide additional insight into a borrower’s creditworthiness.
Single households
Another shift in the market affects the treatment of the number of borrowers during underwriting. Previously, Fannie Mae’s Desktop Underwriter (DU) assigned a higher risk when a loan had only one borrower. The enterprise has now removed the number of borrowers as a risk factor.
In the U.S., the proportion of single-individual households has increased from 13.3% in the 1960 Census to 27.6% in the 2020 Census. In the same timeframe, the proportion of households with children led by two parents decreased from 85% to 70%.
Rather than using the number of borrowers as a risk factor, Fannie Mae’s underwriting model will continue to lean on other data, such as an applicant’s credit profile and property evaluation. The policy shift will make homeownership more accessible to single-individual households and single-parent families, which were penalized by the previous standards.
Duplex thresholds
Fannie Mae changed its loan-to-value (LTV) and combined LTV requirements on two- to four-unit residential homes, effective November 2023. The government-sponsored enterprise reduced the minimum downpayment on owner-occupied multi-unit homes from 15% on duplexes and 25% on triplexes and fourplexes to 5% on all.
The lower downpayment threshold will provide mortgage access to borrowers traditionally sidelined by the higher downpayment requirements and increase affordable rental housing for low- and moderate-income renters, according to Fannie Mae.
Additionally, the change will echo the Federal Housing Administration’s (FHA) handling of multi-unit primary residences. FHA loans for two- to four-unit properties have the same 3.5% minimum downpayment as single-unit homes. Fannie Mae’s new downpayment requirements apply only to automatically underwritten loans, including the company’s HomeStyle Renovation mortgage and non-cash-out refinances.
Looking forward
Ultimately, new approaches to mortgage underwriting have the potential to hasten the lending process and boost lender profitability, while, at the same time, making mortgage borrowing more accessible to a wider pool of qualified borrowers.
Though this is worth celebrating, adoption of new underwriting tools and standards cannot be done haphazardly. Without proper consideration for the risks that may come with greater automation and less emphasis on traditional income and credit-worthiness requirements, lenders could find themselves taking on undo risk, while borrowers become saddled with debt they cannot afford.
Nonetheless, through careful implementation and further refinement of new underwriting practices, the lending industry and broader housing market could become stronger than ever before. And that will only offer more chances for both borrowers and originators.
