Real Estate Underwriting: Definition, How It Works, and History

What Is Underwriting?

Underwriting is the process used by lenders and insurers to evaluate risk. For lenders, it is used to determine how likely a borrower is to be able to pay back the loan. For insurers, they evaluate how likely it is that an insurable event will happen and when it might occur.

In both fields, underwriting is used to set prices for their products. Underwriting helps determine how much of a premium someone will pay for their insurance, how fair borrowing rates are set, and also sets prices for investment risk.

Underwriting is used in various sectors including lending, insurance, and investments. It also has an important place in real estate and mortgage lending.

Key Takeaways

• Underwriting is the process lenders use to determine the creditworthiness of a potential customer and minimize risk to the lender.
• Underwriters research applicants’ credit scores and financial history to determine how risky it will be to offer them a mortgage.
• Real estate underwriters determine whether the property’s sale price meets its appraised value and ensure no one else is on the title.
• Underwriters also evaluate whether natural disasters are likely to pose any dangers to the property.
• Underwriting determines whether a customer is offered a mortgage and, if so, at what interest rate.

History of Underwriting

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 their name under text describing the venture and the total amount of risk they were 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.

How Underwriting Works in Real Estate

In real estate, mortgage lenders use underwriting to evaluate the potential risk of a loan. Underwriters look at the financial history of a potential borrower to determine how likely they are to be able to pay back the mortgage. In its most basic form, underwriting is the fact-checking and due diligence done by a lender before assuming any risk.

Along with looking at the truthfulness of an individual’s application, underwriters research how risky it will be to lend to that person before offering a loan. To determine creditworthiness, an underwriter might look at:

• Credit history, including history of loan repayments, defaults, and bankruptcies
• Credit score
• Current bank balances and other assets
• Any outstanding loan balances
• Employment history and income

How creditworthy the customer is will impact what interest rate they are offered on their mortgage or whether they are offered a mortgage at all.

Important

Real estate underwriters are different from securities underwriters, who are responsible for determining the offer price of financial instruments.

Underwriting and Property Appraisal

In addition to looking at the potential borrower, real estate underwriters also look at the property being purchased to determine whether its sale price meets its appraised value.

Borrowers are required to have an appraisal conducted on the property they want to buy with a mortgage. 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 also check other information about the property that could impact the lender’s risk, such as:

• Whether anyone other than the seller is listed on the property title
• Whether natural disasters such as floods or wildfires post a danger to the property

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 mortgage request has a greater chance of being accepted.

What Is a Property’s Appraised Value?

In real estate, a property’s appraised value is the value of a property at a certain point in time. This is determined by a professional appraiser before a mortgage is issued. Appraised value is usually based on a number of factors, including the assessed property value and the worth of any physical structures. Appraised value may not be the same as market value, which is what it costs to actually buy the property on the open market.

How Can I Improve My Creditworthiness?

Lenders look at a borrower’s creditworthiness before issuing a loan. Paying bills on time and reducing your debt-to-income ratio are generally the best ways to improve your creditworthiness. You can do this by reducing debt and/or by increasing your income. Removing errors from your credit report can also help.

What Is Collateral?

Collateral is an asset that is promised as security on a loan. If the borrower can’t make their payments and defaults on a loan, then the lender has a right to seize the assets pledged as collateral. In the case of a mortgage, the property itself is the collateral.

The Bottom Line

Underwriting is a process of research and due diligence used in many areas of the financial industry in order to minimize risk. In real estate, underwriters research the credit and financial history of potential borrowers to determine how risky it will be to issue them a mortgage.

A borrower’s creditworthiness, as decided by an underwriter, determines whether they are offered a mortgage and at what interest rate. Underwriters also looked at the property, including its appraised value and the potential for any natural disasters, when assessing risk. Underwriting is used in areas other than real estate as well, including insurance and securities.