Lenders assess mortgage risk by checking credit scores, debt-to-income ratios, home appraisals, and pricing loans accordingly. Mortgage insurers and investors also share the risk.
Lenders who write mortgages must consider the danger posed by borrowers who prove unwilling or unable to make agreed-upon mortgage payments. Financial professionals refer to potential borrower default as mortgage risk. Loan underwriters should assess the likelihood of missed 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 mortgage applicants’ credit scores by pulling their credit history reports. Credit reports allow lenders to assess a loan applicant’s ability to make timely loan payments. People with poor credit scores have a higher degree of mortgage risk and are often ineligible for loans.
Loan originators gather documents including recent income statements, tax returns, and pay stubs to verify loan applicants’ monthly income. Anyone with a high debt-to-income (DTI) ratio exposes the lender to a higher level of mortgage risk because the lack of excess cash leaves the borrower ill-equipped to deal with unexpected expenses. To minimize mortgage risk, many mortgage originators do not make loans to people with DTIs above a certain percentage, such as 45 percent.
Home appraisals play an important role in establishing the risk level of a particular loan. The amount of a mortgage cannot exceed the value of the home used as collateral. To reduce the risk to the lender of depreciating home prices, most lenders limit loan-to-value (LTV) ratios, with 80 percent being a common limit. People with high credit scores, low DTI rates, and homes in desirable locations may be able to establish mortgages with higher LTV rates.
After establishing 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 by subprime borrowers. People with excellent credit are rewarded with low rates and less stringent underwriting guidelines.
Financial institutions share the inherent mortgage risks with other entities, such as mortgage insurers and investors. Mortgage insurers charge monthly premiums to insure the lender in the event of a borrower’s default. Investment companies buy mortgages and divide them into bonds that are sold to investors. People who buy mortgage-backed bonds receive interest payments derived from the mortgagor’s monthly payments. Investors are exposed to mortgage risk because if the borrower defaults, mortgage bonds lose their value.
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