Underwriting is just a fancy way of saying, “What are the chances this money I am lending comes back to me and what risks are involved?”
At its core, there are two different methodologies in underwriting. One is the traditional bank route, which focuses heavily on the borrower’s ability to repay. The other school of thought is usually found within private money lending and is based more on the underwriting or risk assessment of the asset itself.
There tends to be more paperwork in the traditional bank route, but the rates and terms are generally more favorable to the borrower. On the other side, the speed of underwriting and nature of loan processing in private money has a much different feel. Both kinds of underwriting have a home in the lending world. The choice of which route to take comes down to mortgage originators doing the proper research to determine which type of lender and product will work best for each client’s specific situation.
Bank and nonbank underwriting
Most residential borrowers experience the traditional underwriting route through a bank or a nonbank lender, because most people only get a mortgage loan when buying their primary residence. The same cannot be said for real estate investors who, if they need financing, most often go through a private money lender. Either way, it is important for mortgage originators to help their borrowers understand how underwriting works and what is happening.
If you’re a residential mortgage originator, this explanation should be easy when dealing with a traditional home loan. Underwriters at banks and nonbank lenders tend to focus on the borrower. The asset itself has to meet some basic criteria, but the strength of the borrower’s finances and ability to repay the loan tends to be heavily weighted in the risk assessment.
A good time to have this discussion is when you are filling out a loan application with a borrower. The traditional underwriting process requires a lot of documentation, so it is important for borrowers to be aware upfront of what will be required from them as the loan application moves through the process.
Most originators who do a lot of loans will have a niche they specialize in, so they have developed a relationship and understanding with the specific lender that will underwrite the loan and are familiar with their underwriting procedures. This allows for a smooth transition between originator and lender as well as clear expectation setting for the borrower.
When working on a traditional loan, make sure your borrowers understand the importance of things like credit, stated income and tax returns, all of which can play a major role in determining if they will receive the loan. Although some lenders like having their own particular forms filled out, underwriting forms are normally standardized on loans being sold to Fannie Mae and Freddie Mac. These standardized forms make it easier during the underwriting process to calculate things like stated incomes, debt-to-income ratios and the financial obligations of the borrower.
“ True private and hard money loans won’t require W2s, tax returns, bank statements or other documents related to the borrower’s financial situation like a bank requires. ”
There are some drawbacks to dealing with traditional underwriting for both borrowers and originators, however. The loan process from application to closing tends to be quite lengthy because there can be a lot of moving pieces that all have to line up just right for the loan to be approved. The traditional loan underwriting process also tends to fail borrowers who have blemishes in their personal finances because it focuses so heavily on those factors.
Private money underwriting
The underwriting performed in the private money or hard money world is much easier on borrowers who don’t have perfect credit and financials. It also can be completed much more quickly, which is often advantageous, especially in the world of real estate investment. Many originators find private money underwriting easier to deal with as well because it is heavily asset-driven and requires little paperwork to get a transaction to the table.
The downside to this side of the fence is that interest rates at banks and nonbank lending institutions tend to be more favorable than in the world of private money. Private money and hard money also are not models that normally scale up to a national level. Most private lenders will have less than $10 million to deploy on a yearly basis and, for the most part, they will have their own required paperwork, underwriting process and risk assessment on a submitted deal.
The draw of hard money is that access to funding and speed of closing tend to be quite rapid. Many real estate investors and commercial brokers lean toward private money and hard money over traditional bank lending when working on loans to purchase investment properties because they want to close quickly and begin the work that will help them turn a profit on the deal.
Residential mortgage originators would do well to have a few private money lenders in their circle in case a deal falls through with a traditional funding source that they wish to save, or if they have clients who need to secure funding quickly — such as buyers competing on a property in a very tight housing market.
When it comes to underwriting, private money lenders normally put a pronounced amount of weight on the deal itself. In addition, the forms and information that an originator will need to send for underwriting will vary widely from lender to lender.
Private money underwriting is not a “plug-and-play” process. Each private lender will have its own required forms and/or submission procedure. Some lenders are strict with the documents they receive from originators and others are not.
True private and hard money loans won’t require W2s, tax returns, bank statements or other documents related to the borrower’s financial situation like a bank requires, however. This is because, in many cases, the underwriter also is the lender that is ultimately financing the loan, so they want to make sure that the asset being purchased is the first line of protection against loss in the event the borrower does not pay.
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Both private funding and traditional institutional lending have their place in the retail and investment world. The underwriting process for these two different lending types is so far apart that they should probably have different terminology. One of the major differences between the two financing paths, however, is that traditional funding focuses more on the borrower than the asset, while the private money route puts more emphasis on the asset itself when determining the risk assessment.