Lloyd's of London is credited as the entity that came up with the term underwriting. The English insurance broker, which dates back to the 17th century, gathered individuals to issue coverage for risky ventures such as sea voyages. In the process, each risk-taker literally wrote his name under text describing the venture and total amount of risk he was willing to accept in exchange for a specified premium. This later came to be known as underwriting the risk.
Although the mechanics have changed over time, underwriting continues today as a key function in the financial world. It is used in various sectors including lending, insurance, and investments. But it also has an important place in real estate. This article explains what underwriting is, and how it relates to this industry.
- Underwriting is the process lenders use to determine the creditworthiness of a potential customer.
- The underwriter researches to ensure applicants represent themselves truthfully and to get a sense of the applicant's finances.
- For real estate transactions, underwriters also determine whether the property's sale price meets its appraised value.
- Underwriters also ensure there's no one else on the title, and whether there are any dangers to the property due to natural disasters such as floods or earthquakes.
What Is Underwriting?
Underwriting refers to the process lenders use to determine the creditworthiness of a potential customer. It's a very important part of the financial business because it helps determine how much of a premium someone will pay for their insurance, how fair borrowing rates are set, and to also set prices for investment risk.
Along with looking at the truthfulness of an individual's application, underwriters research how risky it will be to lend to or insure that person before doing business with that individual or company. So, in essence, underwriting is the fact-checking and due diligence on the insurer or lender's part before assuming any risk.
The U.S. Department of Housing and Urban Development (HUD) defines underwriting as "the process of analyzing a loan application to determine the amount of risk involved in making the loan; it includes a review of the potential borrower's credit history and a judgment of the property value."
How Underwriters Work
The underwriter conducts research to ensure applicants represent themselves truthfully and to get a sense of the applicant's finances. For real estate transactions, underwriters also determine whether the property's sale price meets its appraised value.
The underwriter is responsible to determine the potential borrower's creditworthiness, and assign him or her a rating. This rating, determined by credit scores provided by the three major credit bureaus, represents the applicant's ability to repay the loan, the amount of funds he or she has in reserve, and his or her employment history.
Underwriting and Real Estate
When an individual or business entity seeks funding for a real estate project or purchase, the loan request is scrutinized by an underwriter to determine how much risk the lender is willing to accept. These types of underwriters are not to be confused with securities underwriters, who determine the offer price of financial instruments. Real estate underwriters take into consideration both the land and the borrower.
Borrowers are required to have an appraisal conducted on the property. The underwriter orders the appraisal and uses it to determine if the funds from the sale of the property are enough to cover the amount lent. For example, if a borrower wants to purchase a home for $300,000 that an appraisal deems to be worth $200,000, the underwriter is unlikely to approve the loan or, at least, a loan for the full $300,000.
Underwriters order the appraisal and use it to determine whether the funds from the sale of the property are enough to cover the amount lent.
Underwriters also make sure other factors with the property are in check. This includes ensuring there's no one else on the title, and whether there are any dangers to the property due to natural disasters such as floods or earthquakes.
In most real estate loans, the property itself is used as collateral against the borrowed funds. Underwriters generally use the debt-service coverage ratio (DSCR) to determine if the property is able to redeem its own value. If so, the loan is a more secure proposition, and the loan request has a greater chance of being accepted.