After the loan application is filed, the loan is considered to be part of the "pipeline," which suggests that there is a planned sequence of activities that must be completed before the loan is funded. At application, the borrower can either lock in the rate of the loan or let it float until some point before the closing. From the perspective of the lender, there is no interest-rate risk associated with the loan until it is locked in. However, after the loan is locked in, the lender is exposed to market interest-rate risk in the same fashion as any fixed-rate asset. Many lenders track locked-in loans and floating liabilities separately, giving rise to the nomenclature of the committed versus the uncommitted pipeline.
There are several factors that are considered important in evaluating both the creditworthiness of a potential borrower and the overall riskiness of a loan.
Several firms collect data on the payment histories of individuals from lending institutions and use sophisticated models to evaluate and quantify individual creditworthiness. The process results in a credit score, which is essentially a numerical grade of the credit history of the borrower. There are three different credit-reporting firms that calculate credit scores, namely, Experian (which uses the Fair Isaacs model), Transunion (which supports the Emperica model), and Equifax (whose model is known as Beacon). While the credit scores have different underlying methodologies, the scores generically are referred to as "FICO scores." Lenders often get more than one score in order to minimize the impact of variations in credit scores across providers. In such cases, if the lender obtains all three scores, generally the middle score is used, whereas the convention is to use the lower metric in the case of the availability of only two scores.
Credit scores are useful in quantifying the history of the potential borrower with respect to both ability and willingness to pay debts in a timely fashion. The general rule of thumb is that a borrower needs a credit score of 660 or higher to qualify as a "prime" credit. Borrowers with a credit score below this level can obtain loans either through the government programs (mainly the FHA) or through subprime lending programs, which involve higher rates or additional fees or both.
The loan-to-value (LTV) ratio is an indicator of borrower leverage at the point when the loan application is filed. The LTV calculation compares the value of the desired loan with the market value of the property. By definition, the LTV of the loan in the purchase transaction is a function of both the down payment and the purchase price of the property. In a refinancing, the LTV depends on the requested balance of the new loan and the market value of the property. If the new loan is larger than the original loan, the transaction is referred to as a "cash-out refinancing." Otherwise, the transaction is described as a "rate-and-term refinancing."
The LTV ratio is important for a number of reasons. First, it is an indicator of the amount that can be recovered from a loan in the event of a default, especially if the value of the property declines. The level of the LTV ratio also has an impact on the expected payment performance of the obligor because high LTV ratios indicate a greater likelihood of default on the loan. While loans can be originated with very high LTV ratios, borrowers seeking a loan with an LTV ratio greater than 80% generally must obtain insurance for the portion of the loan that exceeds 80%. As an example, if a borrower applies for a $90,000 loan in order to purchase a property for $100,000, the borrower is required to obtain mortgage insurance (MI) on the $10,000 that causes the LTV ratio to exceed 80%. Mortgage insurance is a monthly premium that is added to the loan payment and can be eliminated if the borrower's home appreciates to the point where the loan has an LTV ratio below 80%. Alternatively, certain lenders also "self-insure" the loan, which results in the borrower opting for a higher rate instead of the addon insurance payment. While mortgage insurance can be lifted, the differential higher interest rate cannot be reduced once the LTV ratio is below 80% without refinancing the loan. However, the entire interest amount of the higher mortgage rate is tax deductible, whereas the private mortgage insurance payment is an after-tax payment.
Another measure used in the underwriting process is the combined LTV (or CLTV) ratio, which accounts for the existence of any second liens. A $100,000 property with an $80,000 first lien and a $10,000 second lien will have an LTV ratio of 80% but a CLTV ratio of 90%. In fact, it is fairly common to see these loans being originated together in a piggyback transaction, which allows the borrower to avoid paying mortgage insurance on the first lien. For the purposes of underwriting a loan, CLTV ratios are more indicative of the credit standing of the obligor than LTV ratios and therefore are a better gauge of the creditworthi-ness of the loan.8
In order to ensure that borrowers' obligations are consistent with their income, lenders calculate income ratios that compare the potential monthly payment on the loan with monthly income. The most common measures are front and back ratios. The front ratio is calculated by dividing the total monthly payments on the home (including principal, interest, property taxes, and homeowners insurance) by the pretax monthly income. The back ratio is similar but adds other debt payments (including automobile loan and credit card payments) to the total payments. Generally, the limits for front and back ratios are 28% and 36%, respectively.
Lenders traditionally have required potential borrowers to provide data on their financial status and to support the data with documentation. Loan officers typically required applicants to report and document income, employment status, and financial resources (including the source of the down payment for the transaction). Part of the application process routinely involved compiling documents such as tax returns and bank statements for use in the underwriting process. However, over the last several years, there has been a relaxation in documentation standards through the growth of new programs that no longer demand the same degree of documentation. The offset, of course, is that such borrowers pay higher interest rates for reduced documentation loans.
This trend toward reduced documentation began in the mid-1990s, with increased lending to self-employed borrowers who had both variable incomes and limited means of documenting such income owing to the inherent nature of employ
8. This, of course, assumes that the lender is aware of all loans made on the property; a loan made against a property carrying an unknown or "silent" second lien likely would result in an overly leveraged loan and a higher probability of ultimate principal loss.
ment-related income variability. The tradeoff for originating such products was to charge borrowers higher rates to compensate the lender for the incremental risk associated with the loan. Subsequently, reduced- and no-documentation loans have become increasingly popular. Popular options include loans that require the borrower to supply an income figure but do not require supporting documentation (stated-income loans) and programs that require no disclosures on the part of applicants regarding income, assets, and/or employment [so-called no income/no asset (NINA) loans]. All these programs, as well as others developed using the same logic, are priced to reflect the incremental credit risk relative to standard full-documentation loans.
The increased flexibility in documentation standards is part of a general trend toward risk-based pricing. In the risk-based pricing regime, qualified borrowers with nonstandard characteristics are not denied credit but are charged an incrementally higher rate based on a quantification of their increased riskiness. This quantification of the incremental risks is enhanced as investors provide greater price discovery for pricing such risks by investing in credit tranches of securitized structures collateralized by such loans. The move toward risk-based pricing is primarily responsible for the plethora of programs that have developed over the last decade to accommodate the borrowing needs of various nontraditional borrowers. This trend arguably also has created a fairer credit market because the standard borrower with stronger credit characteristics and full documentation no longer subsidizes the more marginal credits.
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