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Lenders must assess mortgage risk, the likelihood of non-payment or abandonment, using credit checks, income verification, home appraisals, and loan pricing. Mortgage insurers and investors also share inherent risks.
Lenders taking out mortgages need to consider the danger posed by borrowers who prove unwilling or unable to make agreed mortgage payments. Financial professionals refer to potential borrower default as mortgage risk. Loan underwriters must assess the likelihood of both non-payments and complete abandonment of the loan.
Financial institutions use many tools to calculate the level of mortgage risk involved in each loan. The first tool used by lenders is a credit check. Most lenders check the credit scores of mortgage applicants by pulling their credit history reports. Credit reports allow lenders to evaluate a loan applicant’s ability to make timely loan payments. People with poor credit scores pose a greater degree of mortgage risk and are often ineligible for loans.
Loan originators collect documents including recent income tax returns, income tax returns, and pay stubs to verify loan applicants’ monthly income. Anyone with a high debt-to-income ratio (DTI) exposes the lender to a greater degree of mortgage risk because the lack of excess liquidity leaves the borrower ill-equipped to meet unanticipated expenses. To minimize mortgage risk, many mortgage issuers do not lend to individuals with DTI ratios above a certain percentage, such as 45 percent.
Home appraisals play an important role in establishing the risk level of a particular loan. The loan amount cannot exceed the value of the house used as collateral. To reduce the lender’s risk posed by depreciation in home prices, most mortgages cap loan-to-value (LTV) ratios, with 80% being the common limit. People with high credit scores, low DTI ratios, and homes in desirable locations, may be able to take on higher LTV ratio mortgages.
After determining the level of mortgage risk a particular loan represents, lenders must price the loan. To mitigate the risk of default, lenders charge higher closing costs and interest rates on loans taken out by high-risk borrowers. People who have excellent credit are rewarded with low rates and less stringent underwriting guidelines.
Financial institutions share inherent mortgage risks with other entities such as mortgage insurers and investors. Mortgage insurers charge monthly premiums to insure the lender if the borrower defaults. Investment firms buy mortgages and split them into bonds that are sold to investors. People who purchase mortgage-backed bonds receive interest payments that result from the borrower’s monthly payments. Investors are exposed to mortgage risk because if the borrower defaults, the mortgage bonds become worthless.
Smart Asset.
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