Credit Underwriting Process: Step by Step Guide

Describe the Credit Underwriting Process

  1. Introduction

Financial analysis is the main key in determining the expected viability and potential profitability of a project or business. Credit analysis is the method by which banks and other financial organizations evaluate the ability of a potential borrower, an individual or company, to honor their financial obligations. This can involve the lending institution to analyze the financial statements of the borrowing business or individual before taking the risk of issuing or renewing a commercial loan. The main objective of credit analysis is to critically look at the financial status of both the borrower and the lender. The risk rating is derived by evaluating the credit worthiness of the borrower basing it on their likelihood to repay back promptly or to default. Before facilitating the loan, the lending institution primarily scrutinizes the cash flow of the borrower.

The credit analyst closely examines the value of the offered collateral, sources of repayments, credit history and the management ability of the borrower. This involves the employment of various financial techniques such as ratio, trend analysis, creating projections and cash flow analysis. The analysts predicts the severity of the loss to be incurred in case the borrower defaults the loan.

  1. How Underwriting Works

Underwriting is the process through which a lender decides the credit worthiness of a loan applicant or potential borrower with an aim of avoiding undue risks in the company. It is the process used by banks and other lending institutions to assess the ability of the potential borrower to repay the loan by analyzing their credit history, collateral and capacity. The term ‘underwriting’ originated from the traditional practice of requiring the risk taker to write their name under the total amount of the risk they are willing to undertake for a stipulated specific premium. Though the dynamics have changed, the underwriting process is still a key tool in the financial market. Underwriting involves performing a thorough research and coming up with an accurate evaluation of the degree of risk that the loan applicant will bring to the involved company. This helps in setting up a fair risk rate as well as establishing an appropriate premium that would cater for the exact cost of insuring a policy holder. The risk, in case of a loan, has to determine whether the borrower will promptly repay or default. In the case of an insurance the risk rules out the likelihood of so many different policy holders filing claims at the same time while in securities, it caters for the underwritten investment becoming a loss as opposed to the projected profit. Loan underwriting process involve the lender determining the acceptability of risk in approving the potential borrower’s loan application. This is primarily a scrutiny in the borrower’s ability to repay based on an analysis of their capacity, credit and their collateral. In capacity, the underwriter considers the borrower’s current employment status, debt and assets and their income. This reports is available both in the credit reports and the loan application form of the borrower. Business credit reports which are thoroughly researched, proved and full of important details for both small and medium enterprises are readily available in various analytical models to both private and public entities all over the globe. To determine the credit of the borrower the underwriter, check on the credit score and credit history in terms of repayments schedule of their previous loans. The underwriter answers such questions as, ‘has the borrower been declared bankrupt, or their assets repossessed or their debts going into collections?’ Collateral is a valuable item that a lender can seize from the borrower in case they default a loan according to the agreed terms. It is an asset or property that a borrower offers to the lenders security for a loan.

To ensure a smooth underwriting process, the borrower need to ensure: quick response to enquiries. When the lender requests additional financial documents, bank statements or any other information they should provide it the soonest possible to avoid delaying the process. Second, the borrower need to be open and honest. The underwriter is capable of detect any form of dishonesty about the borrower’s income, credit history or assets hence no need to hide or distort such crucial information. Thirdly, the borrower should avoid making major financial changes. One should not apply for any credit lines during the underwriting process. One should also avoid making any purchase that could result into a decrease of their assets they had at the time of the application.

  1. Factors to Consider When Developing Underwriting Rules

Besides assessing risks underwriting systems aid in the management process. When it is designed well, it can be an effective tool in management. A well-managed system guides the underwriter to approve cases with clear guidelines.

  • Invest in Classification of rules:

While classifying the rules it is advisable to organize them by function, flexibility or the product they are to govern. When rules lack an established structure they can end up being inefficient in the future.

  • Establish definite structure of rules:

When rules lack a well-defined structure it makes it more challenging to maintain them. Successful institution structures complex rules into completely inclusive, rule sets which eases the burden of maintenance.

  • Create a Proper Governance:

Governing rules need to be developed as an ongoing continuous process. If rules are treated as a one-time requirement, solving future problem can turn out to be challenging and tedious.

  • Analyze How to Use of the Rules:

Considering the dynamics of advances in technology, carriers need to analyze the success rate of the set rules and keep on improving their overall performance.

  1. Types of Underwriting

Basically, there are three types of Underwriting:

  • Insurance underwriting:

This type of underwriting focuses on the policy holder seeking health or life insurance.

For Example: The underwriter in a health insurance company considers factors such as the age, lifestyle, health, occupation among others to determine the risk involved. The underwriter decide the coverage to be received by the client, the total amount they should pay for it. Here the underwriter majors on reviewing the medical history of the client while making the final decision whether to insure or decline.

  • Securities Underwriting:

This mostly regards to Initial Public Offering (IPO). This is a process of distributing issued securities (equity or debt capital) such as bonds and stocks to the investors. This seeks to assess the risk and the best price for various securities. Security markets are based on the auction with the buyer searching for the lowest prices and the seller looking for the highest bidder.

  • Loan Underwriting

This involves researching on the applicant’s credit history, financial statements, and the value of the collateral and purpose of the loan. It is an appraisal process that ties place within a span of days or weeks depending on whether is done manually or electronically. Mortgage is the most common type of loan underwriting that most people encounter.

  1. The Underwriting Cycle

The underwriting cycle, also known as the insurance cycle refers to the fluctuations in the insurance business over a specific span of time, whereby the business goes from boom to bust and to boom again. The underwriting process in mortgage involves the underwriter first verifying the submitted documents of the applicant, checking their credit history and assessing their financial situation in terms of their generated income, cash reserves, accrued asset, and equitable investment among other risk factors. To understand the potential borrower’s financial situation the underwriter looks into factors such as: their credit score, credit reports and the property they intend to buy. This helps to determine and analysis the overall risk of defaulting the mortgage. According to Fannie Mae’s underwriting guidelines, the lender requires maximum loan-to- value (LTV) ratio of 95 percent, a credit score of t least 680 and a 36 percent of maximum debt-to-income (DTI) ratio.

 

Incase one fails in one of the above factors, the loan still be approved based on the strength of the following factors: LTV ratio, Amortization schedule, credit score, the borrower’s chances of occupying the said property, the type of property in terms of units, DTI ratio and financial reserves.

 

  1. Steps of the Mortgage underwriting process

Step 1: Application for the mortgage:

This step requires the potential borrower to fill out an application form either in person or electronically. The lender typically gathers personal information about the borrower’s identity residential history, income, debts, employment status and financial investments. In some cases they can request for copies of recent tax returns, credit report bank statements among others.

 

Step 2: Receive the loan estimate from the lender:

This is a document the lender gives for reviewing. It is an estimate explanation of the borrower’s monthly payment mode, interest rate, total cost and principal for the first five years. It also elaborates the percent borrower will have to pay in interest over the entire life of the loan.

Step 3: Loan processing:

It is at this stage that the lender or loan processor gathers all the information pertaining the borrower’s personal and financial details from their Mortgage application. This gives way for the underwriter to start checking this data with an aim of verifying any potential risks or gaps.

 

Step 4: Mortgage Approval, Suspension or Denial:

In most cases, the underwriter will approve the mortgage loan application though with some conditions or contingencies. This requires the borrower to add more information in terms of documentation or an appraisal.  Other times they can suspend or deny consideration to their findings after thorough research on the borrower’s credibility.

 

Step 5: Clear any Loan Contingencies:

This allows the borrower to z closely with the lender to ensure that the borrower clear any contingencies found in stage 4. Once all the conditions are met, they will receive a “clear to close” from the lender.

 

Step 6: Close on the House:

The closing disclosure will be issued at least three days before the closing date as part of the closing process. After renewal of the loan details such as the monthly payment and the needed closing amount, the borrower will close and receive the keys to the new house. This officially completes the mortgage loan process.

 

  1. Steps In the Insurance Underwriting Process

The insurance underwriting process has two major broad parts namely: financial and medical underwriting. The financial part enables the underwriter to estimate the cost of coverage basing it on the family’s need and the number of family members to be covered. Medical underwriting on the other hand, is where the underwriter determines the total cost of risk to insure basing it on factors affecting the applicant’s mortality. Proposal form, age proof, income documents and Client Confidential Report (CCR) are some of the underwriting tools that helps the underwriter to have a smooth insurance underwriting process.

Step 1: Apply for Quality Check: Once the initial application has gone through and he information provided there in is verified to be correct and complete, application goes into the official underwriting process. This stage ensures that the application gets the right premium for the policy they are paying for.

Step 2: Medical Examination: Not all applicants are required to give a detailed medical examinations. However, this stage involves a cross-examination of the paramedical results. The medical test, is needed to be done, is a simple checkup done by a doctor recommended by the insurance company. The underwriter basically checks on such information as the basic measurements (height and weight), blood and drug tests. Blood tests gives information on underlying diseases such as stroke, diabetes, heart diseases, among others. A drug test is a urine test to determine consumption of alcohol, drug and/or smoking.

Step 3: Rating the Application: after approving both the medical and financial information, the applicant is either given a counter offer to review or is offered the requested life insurance policy. The evaluation done determines the premium that is needed to be paid based on the choice of the applicant age, gender, medical history, occupation and lifestyle. Depending on the choice of the applicant, the insurance provider can offer a plan with the lowest premium or a plan with a relatively higher death benefits or investment returns.

 

  1. Conclusion

Naturally, underwriters are the risk managers of the investing company. They evaluate and determine the risk involved as well as checking on the credit worthiness of the potential borrower. They prove this through the information they gather as they research on the credit history, financial statements, collateral and managerial ability of the applicant.

Generally, there are three main stages in the underwriting process.  The planning stage involves, among others, understanding the rationale of the investment and estimating the expected investor demand or interest. The second is the timing and demand stage where the underwriter evaluates the current market conditions, investor experience, benchmark offerings etc. The final stage is the issue structure stage where the decision on formulating the offering structure is made. Questions such as how the sale will occur are answered.

 

For a company to come up with a conclusion of what time are acceptable, the underwriter need to consider the date, statistics and other guidelines provided by the actuaries. The underwriters uses their specialized knowledge on risk management to determine the worth of insuring someone or something and at what cost. They must be able to determine what the actual risk is before approving the insurance cover. To some extent some loans can be approved as exceptions whereby they are approved under conditions that contravenes the bank’s lending policies. In a nutshell, underwriters assess the degree of risks of the insurer’s business.

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