Loan Underwriting Basics: Interviewing, Credit Reports ...Loan underwriting is both a broad and a deep topic. For the purposes of this manual and the associated webinar, for which

Presented by: Tommy Troyer, EVP

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Loan Underwriting Basics:

Interviewing, Credit Reports, Debt Ratios, & Regulation B

Community Bankers Webinar Network

January 2017

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Speaker

Tommy Troyer, Executive Vice President Tommy Troyer is the Executive Vice President of Young & Associates, Inc. and manages the company’s lending division. Tommy contributes to capital planning, strategic planning, and other management consulting services. He also continues to focus on topics related to credit risk management, and assists clients with loan reviews, ALLL reviews, credit process reviews, and other lending-related services. Tommy also presents seminars and webinars related to credit risk management.

Tommy joined Young & Associates, Inc. from the Bank Supervision Group at the Federal Reserve Bank of New York, where he focused on credit risk management practices at supervised institutions. His work included a focus on the ALLL, stress testing, and risk monitoring and reporting practices. Prior to his time in bank supervision, Tommy worked in the Federal Reserve Bank of New York’s Research Group. Tommy holds a B.A. in Economics from Wittenberg University.

Disclaimer This presentation is designed to provide accurate and authoritative information in regard to the subject matter covered. The handouts, visuals, and verbal information provided are current as of the webinar date. However, due to an evolving regulatory environment, Financial Education & Development, Inc. does not guarantee that this is the most-current information on this subject after that time. Webinar content is provided with the understanding that the publisher is not rendering legal, accounting, or other professional services. Before relying on the material in any important matter, users should carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice. The content does not necessarily reflect the views of the publisher or indicate a commitment to a particular course of action. Links to other websites are inserted for convenience and do not constitute endorsement of material at those sites, or any associated organization, product, or service.

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Table of Contents

Speaker ............................................................................................................................................ i

Tommy Troyer, Executive Vice President .................................................................................... i

Table of Contents ........................................................................................................................... i

Section 1: Introduction and Goals of Underwriting .............................................................. 1

Approach to This Manual and Presentation ............................................................................... 1

The Primary Goal of Underwriting: Evaluating the Borrower’s Willingness and Ability to Repay ............................................................................................................................................ 2

Importance of Documenting the Underwriting Analysis ............................................................ 2

Section 2: Applications for Credit and Fair Lending Considerations ............................... 4

Applications for Credit................................................................................................................. 4

Fair Lending Considerations ....................................................................................................... 4

Fair Lending Background ....................................................................................................... 4 Fair Lending Considerations for Requested Information ...................................................... 5 Fair Lending Considerations for the Income Analysis ........................................................... 5 Fair Lending Considerations: Joint Intent and Signature Requirements ............................ 6 Fair Lending Considerations: Policy Exceptions .................................................................... 6 Fair Lending Hot Topics ......................................................................................................... 7

Section 3: Underwriting Consumer Loans and Residential Mortgages............................. 8

Sources of Repayment .................................................................................................................. 8

Assessing the Applicant’s Capacity to Repay .............................................................................. 8

Ability to Repay / Qualified Mortgage Rule ............................................................................ 8 Measuring the Capacity to Repay ........................................................................................... 9

Credit Scores and Credit Reports .............................................................................................. 19

The Credit Score .................................................................................................................... 19 The Credit Report ................................................................................................................. 20

Collateral Analysis .................................................................................................................... 21

A Note on the Loan-to-Value Calculation for Real Estate Loans ........................................ 21

The Applicant’s Balance Sheet .................................................................................................. 22

A Note on the Source of Down Payment Funds for Residential Mortgages ........................ 23

Documenting the Underwriting Analysis Effectively ............................................................... 23

Loan Underwriting Basics

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Section 4: Underwriting Commercial Loans ......................................................................... 25

Sources of Repayment ................................................................................................................ 25

Applications and Information to Gather ................................................................................... 25

Assessing the Capacity to Repay ............................................................................................... 26

A Note on Financial Information Needs for Commercial Loans .......................................... 28 Assessing the Business’s Balance Sheet ............................................................................... 29

Assessing the Abilities of Management .................................................................................... 30

Collateral ................................................................................................................................... 31

Documenting the Underwriting Effectively .............................................................................. 31

Conclusion .................................................................................................................................. 32

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Section 1: Introduction and Goals of Underwriting Underwriting is the process by which a financial institution evaluates a proposed credit to

assess the level of risk associated with the credit. The purpose of underwriting is to fully understand the proposed credit, accurately assess its level of risk, and effectively document that assessment. This is the work that allows the lending institution to determine whether the loan should be approved or denied by comparing the underwriting assessment to its internal credit standards and its risk appetite (or, in the case of loans intended for sale on the secondary market, by comparing its underwriting assessment to the secondary market investor’s credit guidelines).

An effective underwriting process requires that the following steps be accomplished:

• The right information is gathered • The information is accurately analyzed • The analysis is documented in a clear and useful way

• A conclusion is reached as to whether the proposed loan is consistent with the applicable credit guidelines and should be approved. This part of the process, especially for commercial loans, might also include a determination of the particular terms under which the credit will be granted.

Further, all four of the above steps must be accomplished in a manner consistent with relevant laws and regulations. The specifics regarding how the above steps are accomplished can vary, in some cases significantly, based on the type of credit being underwritten and the particular policies, procedures, underwriting standards, and risk appetite of the financial institution at which the underwriting is taking place.

Approach to This Manual and Presentation

Loan underwriting is both a broad and a deep topic. For the purposes of this manual and the associated webinar, for which space and time are limited and the focus is intended to be on the basics of loan underwriting, the goal is to begin to build a foundation of knowledge upon which additional training and further experience can build. The underwriting or qualifying guidelines that a loan must meet to be approved can vary significantly depending on a number of factors. For that reason, it is impractical for an introduction to underwriting to attempt to provide one-size-fits-all guidelines for qualifying credits, such as what should be considered to be an acceptable credit score or debt-to-income ratio. Instead, our goal here is to discuss the most important factors that should be evaluated in underwriting, the information that should be used to evaluate them, and some best practices related to how those factors can be evaluated. Hopefully, this approach will provide the underwriter with the knowledge to make informed decisions while conducting underwriting analysis. This knowledge, of course, should ultimately be applied by each underwriter in a manner consistent with his or her institution’s policies and procedures.

It should be noted that many of the principles discussed in this manual will be generally consistent with the underwriting practices required by Fannie Mae and Freddie Mac, but because of the level of detail and specificity that these entities have put in place in order to standardize the underwriting of the loans they purchase, this manual is not intended to provide specific guidance on underwriting residential mortgages for the secondary market. Similarly, this manual does not specifically address the underwriting requirements of FHA loans, VA loans, and other similar loan programs.



The Primary Goal of Underwriting: Evaluating the Borrower’s Willingness and Ability to Repay

The primary focus of the underwriting analysis for any extension of credit should be on assessing the likelihood that the borrower will repay the loan in accordance with the loan terms. This is the most important principle in credit analysis. There are of course other important considerations to take into account, particularly how the lending institution will recover the loaned funds if the borrower does not repay the loan as agreed. However, since it is clear that for any loan the best outcome for all involved is the timely repayment of the loan according to the agreed upon terms, the underwriting decision must be based primarily on the likelihood of this outcome.

The assessment of whether or not a borrower will repay a loan in accordance with the agreed upon terms ultimately boils down to just two factors: the willingness of the borrower to repay, and the ability of the borrower to repay. Note that both factors have to be present for timely repayment—one without the other is not sufficient. A borrower who desires to repay a loan as agreed but does not have the necessary financial resources will be unable to do so. Similarly, a borrower with the financial resources to repay the loan but with no willingness to repay the loan is unlikely to repay the loan as agreed. There are many considerations an underwriter must weigh in assessing a borrower’s willingness and ability to repay, but the underwriter should always keep in mind that the purpose of the underwriting analysis is to determine whether or not both factors are likely to remain present throughout the life of the loan being underwritten. Therefore, the majority of the materials discussed in this manual relate to assessing either the willingness or the ability of the borrower to repay.

Importance of Documenting the Underwriting Analysis

Effective underwriting has not been accomplished until the underwriting analysis has been clearly and effectively documented. Doing so is the only way to translate the nuts and bolts of the work performed to assess the proposed credit’s risks and its conformance with the relevant credit guidelines into a usable tool (an underwriting summary).

We will make some recommendations later in this manual for ensuring effective documentation of the underwriting analysis. Here, let us note several reasons why effective documentation of the underwriting analysis is so important:

• Producing effective documentation is the only way that an underwriter or institution can demonstrate that accurate and complete underwriting took place.

• Quality control reviews and/or loan reviews are important aspects of ensuring underwriting quality. Effective and clear documentation is critical to demonstrating to the reviewer that the institution’s underwriting analysis is appropriate.

• Similarly, clear documentation of the underwriting analysis is the most effective way to demonstrate to examiners that an institution is effectively managing the risk associated with credit origination. Examiners (and quality control and loan reviewers) will not watch over an underwriter’s shoulder as they underwrite a loan to determine if the underwriting is proper. They will review the documentation produced from the underwriting after the fact, and thus good documentation is key to a positive assessment.



• On a related note, clear documentation of the details of the underwriting can help make it apparent that the underwriting was done in a way that is compliant with fair lending requirements.

• More generally, the risk posed by inaccurate or ineffective underwriting can best be managed on an institutional level when the underwriting process is repeatable and reviewable. Consistent approaches to documenting the analysis help ensure that these standards are met.

• Finally, on an individual level, the best way for an underwriter to demonstrate the quality of their work and their value to the organization is to produce documentation that makes it clear that the underwriter has done his or her job effectively. Such a conclusion, of course, would also be informed by the observation that an underwriter’s work rarely resulted in any issues or exceptions when reviewed through the quality control or loan review process.


Section 2: Applications for Credit and Fair Lending Considerations

The first formal step in the process of underwriting a proposed credit is for the borrower to

complete an application for credit. At this point, and throughout the underwriting process, the lending institution needs to be aware of important requirements and prohibitions related to fair lending laws and regulations.

Applications for Credit

All proposed credits should be supported by a complete and signed application. A lending institution should use standardized application forms, though more than one form will typically be necessary as applications for different types of credit require different information. Applications should include standard language describing representations of the applicant(s) (for example, that the information provided in the application is true and correct). For residential mortgage loans, the Uniform Residential Loan Application used by the GSEs (Fannie Mae Form 1003 or Freddie Mac Form 65) is the best application to use in most circumstances.

By filling the application out completely, the borrower provides the underwriter with the information that is needed to conduct the underwriting analysis. For example, the borrower’s listing of his or her sources of income on the application tells the underwriter what documents will need to be obtained to verify those sources of income. In important ways, consistently obtaining complete applications can also help protect against fair lending risk by ensuring that information about certain factors that may sometimes be cited as reasons for denying an application are consistently collected. When this information is consistently obtained, the lending institution is able to consistently take those factors into account for all borrowers. By signing the application, the applicant(s) assert(s) that the information provided is accurate.

Fair Lending Considerations

A complete discussion of all of the consumer compliance considerations that impact the loan underwriting process or even a complete discussion of the many aspects of fair lending law and regulation would require much more time and space than available here. For that reason, it is important to begin any discussion of consumer compliance issues by noting that the detailed nature and significant volume of legal and regulatory considerations that impact the end-to-end underwriting process means that effective management can only be achieved through a successful institution-wide compliance management program that includes regular training for underwriters, lenders, processors, and others. The goal here is to highlight some of the most common and significant aspects of fair lending law and regulation that impact loan underwriting. The discussion below is not meant to be all-inclusive.

Fair Lending Background

The Equal Credit Opportunity Act (ECOA) is the nation’s primary fair lending law. Regulation B is the federal regulation that implements the ECOA. The purpose of the ECOA is to promote the availability of credit to all creditworthy applicants. The ECOA prohibits discrimination on the basis of race, color, religion, national origin, sex or marital status, or age. It also prohibits discrimination based on an applicant’s income being derived from a public assistance program, or



because the applicant has in good faith exercised any right under the Consumer Credit Protection Act. In summary, Regulation B focuses on the fair treatment of consumers in the granting of credit.

At its heart, the regulation says the decision to grant credit is to be based on the borrower’s ability to meet the lender’s credit standards. While certain notification requirements included in Reg B are somewhat less stringent for commercial-purpose applications than for consumer applications, it is important to recognize that fair lending laws and Reg B apply to commercial credit as well as consumer credit. Perhaps because of the distinctions made with respect to notification requirements or perhaps because the historical emphasis on fair lending enforcement has tended to focus on consumer credits, one will occasionally hear a lender or underwriter observe that “fair lending doesn’t apply to commercial loans.” This statement is categorically false.

Fair Lending Considerations for Requested Information

The general rule for collecting information is that a creditor should not request or collect information on an applicant’s race, color, religion, national origin, or sex, unless an exception allowed under ECOA applies (the most notable exception being that the information is being collected to monitor compliance with fair lending rules, such as in the collection of Home Mortgage Disclosure Act—HMDA—data). Additionally, a creditor cannot request information about an applicant’s spouse or former spouse unless the information is germane to the credit request, such as when: the spouse will be associated with the account as an obligor or user, the spouse’s income or alimony/child support/maintenance income from the former spouse is considered as a source of repayment, or if the applicant resides in a community property state.1

Additionally, applicants cannot be required by creditors to disclose alimony, child support, or separate maintenance payments unless the applicant wants those sources of income to be considered by the creditor in the repayment analysis. Creditors are required to disclose this fact to the applicant. One of many benefits of an effective and standard application form is that it should include this disclosure in the section where it requests income information from the borrower.

Fair Lending Considerations for the Income Analysis

Under the fair lending rules, creditors cannot discount or exclude an applicant’s income solely because the income is derived from a public assistance program (which is defined to include both entitlement-based programs, such as social security, and need-based programs, such as rent assistance). Similarly, creditors cannot discount or exclude income solely because it is derived from part-time employment. However, certain considerations related to the above sources of income are permitted:

• The length of time the applicant will likely remain eligible to receive such income • Whether the creditor can attach or garnish the income in the event of default • The likelihood of consistent payments of alimony, child support, or separate maintenance

(considering such things as the consistency with which payments are received, the creditworthiness of the payor, and whether the payments are received pursuant to a written agreement or court order)

1 In community property states, state law is such that assets owned by a married person may also be owned by the spouse.



Additionally, creditors may not evaluate married and unmarried co-applicants under different standards. That is to say, the approach to evaluating the creditworthiness of an application with two borrowers must be the same whether the two applicants are married or not.

Fair Lending Considerations: Joint Intent and Signature Requirements

If an applicant requests and qualifies for individual credit, the creditor cannot require the applicant to have a co-signer, guarantor, or similar party in order to receive credit. If an applicant requests but does not qualify for individual credit, the creditor can require a co-signer or guarantor, but it cannot be required that the additional signatory be the applicant’s spouse. The submission of a joint financial statement or other evidence of jointly owned assets cannot be considered by the creditor to indicate that the applicant is making an application for joint credit. There are certain cases where creditors can require spouses to sign certain documents, generally when doing so is necessary to properly secure the collateral being pledged.

Perhaps the most important consideration to be aware of related to Reg B’s joint intent and signature requirements is that, when applicants do intend to apply for joint credit, they should both sign a statement of intent to apply for joint credit to document that fact at the time of the application. Reg B requires that the intent to apply for joint credit be documented at the time of the application. The best approach is to ensure that all credit applications include a section for documenting joint intent, though this can also be accomplished using a separate form.

For commercial loans, Reg B commentary states that the lender may require the signatures of all of a specific type of individual (for example, partners, directors, officers, or shareholders), but the signatures of these individuals’ spouses cannot be required if there is no reason other than because they are the spouse of an officer, director, etc.

Fair Lending Considerations: Policy Exceptions

A policy exception occurs when a lending institution chooses to approve a loan that has some characteristic that does not meet the limits set forth in policy or underwriting guidelines. The lending institution may make such a choice for any number of reasons, if it believes that the full set of facts and circumstances around the applicant and the proposed credit reflects a loan that is within its risk appetite. Approving the occasional loan with a policy exception can be appropriate, however, policy exceptions can also lead to increases in both fair lending risk and credit risk. Policy and underwriting standards exist for a reason, and history indicates that loans approved with policy exceptions do tend to perform worse than loans without policy exceptions.

Further, fair lending risk can arise from approving loans with policy exceptions, especially when a clear, specific documentation of the justification for approving the credit is not provided. Without such a justification, it is quite possible that a fair lending assessment will find that similarly-situated applicants were treated inconsistently (for example, that a male with a 48% DTI was approved for credit based on a policy exception while a female with a 48% DTI was denied). When a clear justification is provided, and the institution is consistent in how it grants exceptions based on that justification, a fair lending review should be able to identify why a particular credit with a policy exception (say, an elevated DTI) was approved while a seemingly similar credit (say, with a similar DTI) was not approved because it did not possess similar mitigating factors.

When a loan with a policy exception is approved, the nature of the policy exception should be noted (for example, DTI exceeds maximum level, credit score below minimum level, etc.), as should



proper approval of the exception. Systematic tracking of policy exceptions should take place. This allows a financial institution to understand the total amount of policy exceptions (and the amount of different types of policy exceptions) it is making, how loans that are approved with policy exceptions have performed over time, and provides some of the raw information to allow the institution to monitor to ensure that policy exceptions are not being granted in a way that is inconsistent with fair lending standards. The surest way to avoid the risk associated with policy exceptions, of course, is to avoid granting them in the first place.

Fair Lending Hot Topics

The observations of Young & Associates, Inc.’s compliance consulting department, as well as public statements from regulatory agencies, suggest that there are a couple of “hot topics” worth noting in fair lending today. These include:

• Credit Report Fees. Examiners have been concerned with lending institutions that charge a higher fee for credit reports to unmarried co-applicants than to married co-applicants. The source of this issue seems often to be the pricing structure of the credit reporting agency, which may charge less for a joint report than for two individual reports. There may be several relatively easy solutions to this situation. If this is an issue for your institution, you should begin changing your practice now.

• Redlining. Redlining has been highlighted as a regulatory priority for 2017. It is recommended that all loans be geocoded to provide the information necessary to understand in what geographic areas your institution is, or perhaps is not, lending.

• Small Business Lending. This has been highlighted as another regulatory priority for 2017. Again, remember that fair lending requirements apply to commercial credits as well as consumer credits.


Section 3: Underwriting Consumer Loans and Residential Mortgages

This section discusses the basics of underwriting consumer loans and residential mortgages. Underwriting consumer loans (such as auto loans, loans for recreational equipment, and personal unsecured loans, among other types) and residential mortgages is similar, particularly with respect to the analysis of the applicant’s financial ability to repay the loan. The typical size of a residential mortgage exposure relative to most consumer loans does often require that the underwriting process be somewhat more detailed and thorough in certain respects, however.

Sources of Repayment

One of the initial tasks of underwriting any credit is to identify—and to document in the underwriting analysis—the proposed loan’s sources of repayment. The subsequent underwriting analysis must be informed by this determination, as a primary purpose of the underwriting analysis is to evaluate the adequacy of the sources of repayment. Fundamentally, an evaluation of the primary source of repayment for most credits equates to an analysis of the borrower’s ability to repay the loan.

With the exception of unsecured personal loans, all consumer loans and residential mortgages should have at least two sources of repayment, a primary and a secondary source. The primary source of repayment for a loan is the expected, and desired, source of repayment. For the significant majority of consumer loans and residential mortgages, the primary source of repayment will be the personal income/personal cash flow of the borrower(s). A portion of the borrower’s income each month is used to make the loan payment, and thus the loan is repaid. Less frequently, the assets of the borrower rather than the income of the borrower may be considered to be the primary source of repayment. The secondary source of repayment is the source of repayment the lender turns to if the primary source proves inadequate. For consumer loans and residential mortgages that are collateralized, the secondary source of repayment is typically the sale of the collateral.

Assessing the Applicant’s Capacity to Repay

This section discusses the fundamentals related to assessing a consumer loan or residential mortgage applicant’s capacity to repay the proposed loan. It begins with a brief overview of an important consideration for closed-end residential mortgages.

Ability to Repay / Qualified Mortgage Rule The Ability to Repay / Qualified Mortgage (ATR/QM) rule is a Consumer Financial Protection

Bureau rule that applies to all banks and credit unions, though some of the specifics of the rule’s impact vary depending on whether or not an institution meets the definition of a “small creditor” under the rule. The rule is implemented as a part of Regulation Z (which implements the Truth in Lending Act) and took effect in January 2014. Its basic requirement is that lending institutions make a good-faith evaluation of a borrower’s ability to repay.

The ATR/QM rule covers most closed-end residential mortgage loans (open-end loans, commonly referred to as HELOCs, are not covered by the rule). It requires that the lending



institution consider eight factors in determining whether the borrower has the ability to repay. All eight factors are items that will be mentioned throughout this manual, and are items that most lenders took account of before the rule was implemented. For reference, the eight items are:

1. Current income or assets used to repay the loan 2. Current employment status (if employment income is used to repay the loan); 3. Monthly payments on the proposed mortgage loan; 4. Monthly payments on other loans secured by the home; 5. Monthly tax, insurance, Homeowners Association Dues, and similar expenses; 6. All other debts, alimony, and child support; 7. Monthly DTI and/or residual income; 8. Credit history

The rule requires that the borrower’s income and debt obligations be verified and documented in the credit file. It also requires that the borrower’s monthly obligations after the loan is made be of a level that will leave the consumer with sufficient residual income/assets left to live on (in other words, that the borrower be able to afford living expenses after making debt payments). The procedures require a current copy of a credit report to be in file. Additionally, the process to determine ATR includes a requirement to test repayment ability on the highest possible payment in the first five years for balloon, interest-only, and negative amortization loans. For adjustable rate loans, the analysis should be based on the fully-indexed rate. This analysis needs to be verified and documented in the credit file. 12 CFR 1026.43(C) and 12 CFR 1026 Appendix Q: Standards for Determining Monthly Debt and Income are the regulatory references for additional information on the ATR rule.

Measuring the Capacity to Repay

For consumer loans and residential mortgages, the capacity of an applicant to repay the debt is typically evaluated using the Debt-to-Income Ratio (DTI). Analysis of the capacity to repay can be supplemented by the consideration of the Housing Ratio and also by a budget or funds remaining analysis.

The DTI and housing ratios are simple enough to calculate in theory: they are calculated by dividing some measure of the monthly payments an applicant must make by that applicant’s monthly income. The key to accurately assessing capacity to repay involves performing an appropriate assessment of the monthly payments and monthly income. In summary, the two ratios can be described as follows:

• Housing Ratio: The Housing Ratio is the ratio of all monthly housing obligations to monthly income. This ratio is also commonly referred to as the Front-End Ratio.

• Debt-to-Income Ratio: The DTI is the ratio of all monthly obligations, including non-housing obligations, to monthly income. This ratio is commonly referred to as the Back-End Ratio.

DTI should be considered in all consumer loan and residential mortgage underwriting. Whether the Housing Ratio is also considered will likely depend on your particular institution’s preferred approach, or, perhaps, on the requirements of the secondary market investor to which you intend to sell the loan. The Housing Ratio can be thought of as a measure that supplements



the information provided by the DTI calculation by showing whether the debt and other payments associated with the borrower’s residence exceed the preferred level or whether the “gap” between the housing ratio and DTI (which measures the impact of non-housing obligations) is significant.

Note that the Housing or DTI ratio required to qualify for a loan will vary depending on a number of factors. One important factor is the methodology used to calculate the ratio. For example, some institutions base their calculation of a borrower’s monthly income on net income (income post-tax and perhaps other deductions) rather than gross income (income before taxes and other deductions). Because the monthly net income for any hypothetical borrower is lower than the monthly gross income, it is appropriate that the maximum acceptable DTI be higher when net income is used to calculate the ratio than when gross income is used. The risk appetite of the lending institution is another important factor in determining the maximum acceptable level. The strength or weakness of other important risk factors, such as credit scores or LTVs, are a final critical consideration in determining the level of the ratio to accept. A borrower with an 800 credit score, 50% LTV and 42% DTI poses a different level of risk than does a borrower with a 600 credit score, 85% LTV, and 42% DTI.

In addition to calculating the ratios described above, some institutions also perform what is variously called a budget, funds remaining, or residual income analysis. This analysis can be considered to be a reasonableness check on the DTI calculation. For example, an applicant with very low personal income but also very low debt levels may have an acceptable DTI, but an analysis of the monthly cash remaining after making debt payments might reveal that an insufficient level of resources remain to cover living expenses. The logic behind the analysis is simply that individuals need to meet monthly living expenses for things like food, gasoline, auto insurance, and utilities, and that as such it is prudent to verify that the amount of their monthly income left over after paying debts and housing obligations is sufficient for doing so.

Calculating Monthly Obligations (the “Debt” of Debt-to-Income)

One way to think about the monthly obligations that should be included in the DTI calculation is to first consider housing obligations (those obligations related to the applicant’s housing expenses, and thus those that would factor into the Housing Ratio) and then consider all other monthly obligations of the applicant.

Housing Obligations For a homeowner or an applicant applying for a residential mortgage, the monthly housing

obligations are the annual payments that the borrower is required to make on their primary residence, expressed on a monthly basis. For example, real estate taxes are typically payable twice per year, but for the purposes of calculating debt-to-income, 1/12th of the annual real estate taxes should be included as a monthly obligation. Typical housing obligations that should be considered, as applicable, include:

• Principal and interest payments on the primary residence (this will typically be the principal and interest payments on the proposed loan being underwritten if you are underwriting a residential mortgage). This is simple for fixed-rate loans. For variable-rate loans, the ATR rule requires that you consider the fully-indexed interest rate (as opposed to a lower introductory rate). The rule includes further requirements if you want to ensure that the loan in question is a Qualified Mortgage (an aspect of the rule too complex for this manual) or if the loan has a balloon, interest-only, or negative amortization structure.



• Principal and interest payments on any secondary financing on the primary residence • Hazard insurance payments (and flood insurance if applicable) • Real estate taxes • Homeowners Association Dues • Private Mortgage Insurance (PMI, which is often required for loans with elevated LTVs) These elements are often referred to as PITI (or PITIA) for Principal, Interest, Taxes, and

Insurance (or Principal, Interest, Taxes, Insurance, and Association dues). Note that in many scenarios the lender will require that most or all of these expenses be escrowed, meaning that the monthly payment paid to the lender each month will cover not only principal and interest but also a payment into an escrow account which will be disbursed by the lending institution to pay insurance and taxes when due. If you are underwriting a consumer loan, it may be necessary to determine, through loan or escrow account statements, whether the payment shown on the applicant’s credit report represents just principal and interest payments or includes an escrow payment for taxes and insurance. If a borrower has a secondary residence, the payments associated with that property must also be factored into the calculation of monthly obligations.

A Note about HELOC Underwriting

When underwriting a Home Equity Line of Credit, it is important that your analysis of repayment capacity factor in the payment the borrower will owe when the line of credit availability ends and the loan begins to amortize. HELOC product structures vary across lending institutions. If your institution’s required payments during the initial “draw period” (the period during which the borrower has access to funds on the revolving line of credit) are interest-only or otherwise low, safe and sound underwriting requires you to ensure that the borrower’s DTI will still qualify when that payment increases to a payment that amortizes the outstanding balance when the draw period ends. Your underwriting should assume that the entire available amount of the line is outstanding at the end of the draw period and should calculate what the amortizing payments would be according to your institution’s loan terms. The need to evaluate capacity to repay in this manner is stated in several pieces of regulatory guidance, most clearly in the interagency 2005 Credit Risk Management Guidance for Home Equity Lending, though it is also suggested in the July 2014 Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods.

A Note about Renters

In many cases when a consumer loan is being underwritten, the borrower will be a renter rather than a homeowner. In this case, the housing obligation to include in the DTI calculation is the applicant’s monthly rent. Since rent does not show up on a credit report in the way that a mortgage payment does, it is important that the application clearly ask what the applicant’s monthly rent is. There are of course situations where an applicant does not have monthly housing expenses, an especially common scenario for a recent high school or college graduate who is still living with one or more parents or guardians. Proper underwriting needs to clearly document what an applicant’s housing situation is, so that there are not questions as to whether an expense as significant as rent has been missed in the underwriting. A relatively common oversight in underwriting consumer loans is to fail to include the applicant’s rent; therefore, if the applicant truly has no rent, it is important to make note of that fact so that the situation is clear.



All Other Monthly Obligations In addition to the housing obligations described above, the monthly obligations included in the

calculation of the applicant’s DTI should include all of a borrower’s other debt or lease payments, such as auto and credit card debt. Other legally required monthly obligations, such as child support, alimony, or similar such payments must also be factored in. Like with monthly rent, child support and alimony do not appear on credit reports. This is why the application for credit and the interview process with the borrower need to identify such obligations. Depending on the nature of the credit and thus the amount of documentation obtained, other information may also reveal the presence of such expenses. For example, alimony paid is deductible on a tax return, and thus the presence of a tax deduction for alimony payments may indicate the presence of a monthly alimony obligation on the part of the borrower.

Note that for the DTI calculation, when an applicant is refinancing existing debt, it is appropriate to exclude the payment(s) on the debt(s) being refinanced. The main concern is with the applicant’s DTI going forward if the proposed loan is made, and the DTI in those circumstances will be influenced by the proposed loan payment, not the existing one(s).

Specific Monthly Obligation Considerations: Credit Cards Credit cards are the most common form of unsecured, revolving consumer debt. It can seem

like there is no right way to handle credit card payments in the analysis since credit cards typically require a minimum monthly payment but often have the potential for the applicant to increase their outstanding borrowings significantly above the current level. Additionally, cards will typically not have a defined repayment plan for the principal as long as the card is being handled as agreed.

In practice, since cards are unsecured and likely to be prioritized after a payment on a primary residence or a vehicle loan, and since timely minimum monthly payments are adequate to keep the card in good standing, the following approach can be taken to calculating debt service:

• If the credit report lists a minimum monthly payment for a credit card, use that amount in your calculation of a borrower’s monthly obligations

• If a minimum payment is not listed, assume a payment of 5% of the current outstanding balance on the card

Specific Monthly Obligation Considerations: Charge Cards Charge cards are different from credit cards in that they do not provide debt that can revolve

from billing period to billing period. Rather, the full amount charged to the card must be paid off each month. This characteristic means the cards are less like other forms of consumer debt and in some ways more like a short-term account payable for a consumer. If a charge card is identified on a credit report and the underwriter determines that the payment history for the card shows no issues and the balance showing on the card represents a reasonable amount for the applicant to afford after meeting housing and debt obligations, the card does not need to be factored into the monthly obligations calculation. This is because the card in this case just represents a different way to pay for monthly living expenses (for example, groceries are charged to the card and paid for once a month rather than being purchased with a debit card and thus paid for at the time of each purchase). The DTI analysis (and budget/funds remaining analysis if utilized) is set up to make sure that there is enough room for living expenses after housing obligations and debt service are paid, meaning that this treatment of charge cards is consistent with the principles of the DTI (and budget/funds remaining) analysis.



Specific Monthly Obligation Considerations: Debt Maturing Soon Some underwriting guidelines do not require that the calculation of monthly obligations

include debt that is scheduled to be paid in full soon. The logic of this approach is that the debt will not be an ongoing obligation for long, and thus that the repayment ability of the borrower over the life of the loan being underwritten is not materially impacted by this debt. Due to the requirements of the residential mortgage secondary market, nine or fewer months is often the rule for determining if a debt can be ignored. However, conservatism and caution are encouraged before a debt is simply excluded from underwriting. If your institution’s underwriting practices permit this approach, the following questions should be asked:

• Is it clear that this applicant has the income and/or liquid assets to make all debt payments until the debt in question is paid in full, even if it is just a few months?

• Is the underwriter certain that the loan will be paid in full in the next few months and is not just reaching a balloon payment (a payment of all of the outstanding balance, due at maturity)? If a loan is ballooning, the borrower will need to have the liquid assets or income to pay the ballooning amount or else will need to refinance the loan, meaning payments will carry on beyond a few months.

• Is the loan likely to be replaced in the near future by a similar loan?

Specific Monthly Obligation Considerations: Leases The second and third considerations in the above section hint at why lease payments owed by

a borrower should always be included in the monthly obligations calculation, no matter the amount of time left on the lease. Auto leases are the most common type of lease for consumers, so we will use that as an example. When an auto lease’s term ends, assuming the consumer still needs a vehicle (which is of course usually the case), the consumer has two options. They can either purchase the car, which will typically require financing and thus an ongoing monthly car payment. Alternatively, they may opt not to purchase the car, in which case they need to lease or buy another car. In either case, monthly car payments are very likely to continue into the future, even if the current lease will be ending soon.

Specific Monthly Obligation Considerations: Debt in Deferment Student loans are the most common type of consumer debt that may be in deferment (meaning

payments are not currently required) at any given time, though there are other types of consumer debt that could be deferred as well. The important principle to keep in mind with respect to deferred debt when underwriting a new loan is that, in many cases, the loan you are underwriting will represent a long-term obligation of the applicant. Residential mortgages are often 30-year obligations, but today even many vehicle loans may be seven-year obligations. As such, debt that is currently deferred will likely require payments before the loan being underwritten is fully repaid. As such, the monthly obligation calculation should include assumptions for payments on debt that is currently in deferment.

If payments are not available from the credit report, the most accurate approach is for the underwriter to obtain the actual payment amount that will be required on the deferred debt. Cooperation from the applicant will be critical to obtaining this information, which should of course be based on verifiable documentation that is kept in the loan file (in other words, the applicant cannot just verbally state what the payment will be). If this information cannot be obtained, the most common convention is to assume monthly payments equal to 1% of the outstanding balance of the deferred debt.



Calculating Monthly Income (the “Income” of Debt-to-Income) When attempting to calculate an applicant’s monthly income for purposes of the DTI

calculation, the overarching principle for the underwriter to keep in mind is that the focus needs to be on estimating the applicant’s stable and recurring monthly income. This is because, in order to ensure that the borrower has the ability to repay the loan throughout the term of the loan (in other words, to ensure that the primary source of repayment appears likely to be reliable throughout the term of the loan), the underwriter’s estimate of monthly income needs to reflect a level of monthly income that is consistent and sustainable for the applicant.

The more common practice for residential mortgage and consumer loan underwriting is to utilize the applicant’s gross income (that is, income before taxes and other payroll deductions), though there are certainly lenders that prefer to look at net income (that is, income after taxes and perhaps other payroll deductions). Which type of income is used is one major factor that will impact the level of the DTI that is required to qualify for credit.

Verifying and Documenting Income Whether an applicant’s monthly income is independently verified or simply accepted based on

what the applicant states on the application depends on the type of loan being underwritten and the lending institution’s preferences and risk appetite. For residential mortgages, the monthly income figure used to underwrite the loan must be verified independently and appropriately documented. This is necessary not only for ensuring quality and safe and sound loans (one needs to look back only 10 years to see the dangers of originating mortgage loans without verifying income) but also for complying with the ATR rule, which requires that “reasonably reliable third-party records” be used to verify an applicant’s income or assets.

Many lenders will verify income for most or all consumer loans as well, though the documentation requirements may not be as extensive as they would be for a residential mortgage. In some cases, especially for lower balance consumer loans such as vehicle loans, underwriting will not independently verify the income level stated by the applicant on the loan application.

The specific documents required to verify income in any situation will depend on your institution’s policies or, if applicable, secondary market requirements. We will discuss below some considerations regarding several typical sources of income verification. For applicants that earn wage or salary income, verification should typically include the several most recent paystubs as well as tax returns and W-2s. Especially for residential mortgages, tax return transcripts are also ordered to further verify the income. Tax return transcripts allow the underwriter to verify that the tax returns provided by the borrower match the tax returns filed with the IRS for a given year. If a borrower is self-employed, recent tax returns will be the primary source of income verification.

If an applicant has his or her primary deposit accounts with your institution, you may have easy access to statements that would verify the frequency and amount of direct deposits or other income into those accounts. However, this option should be looked at as a secondary source of verification, not the primary source. This is because the additional information that can be critical to understanding how to translate a paystub into monthly income (such as the time period covered or the amount of pay that may be overtime, bonus, or commission) cannot be obtained from a deposit account statement.



Verifying Employment As mentioned above, underwriting should be concerned with an applicant’s stable, recurring

income because that is the best predictor of what the applicant’s income will be through the life of the loan being underwritten. An individual’s historical income does not mean much as a predictor of their future income if the individual is no longer employed by the employer that was the source of that income. For this reason, and also because the ATR rule requires verifying current employment status when employment income is being relied upon as the source of repayment, the underwriting process for residential mortgage loans needs to verify a borrower’s employment status near to the time that the loan is closed. A rule of thumb, informed by secondary market requirements, is to do this within 10 days of the loan’s closing.

Verification is often obtained via a phone call to the employer, in what is known as a Verbal Verification of Employment. Verbal verifications need to be documented in the loan file. Using one of the forms provided by the GSEs (Fannie Mae From 1005/Freddie Mac Form 90), even for non-secondary market loans, may be the most efficient way to handle this documentation. Note that the phone number for calling the employer should be independently verified too (a quick internet search will typically suffice) rather than simply relying on a number provided by the applicant. It is also now common for employers to use third-party service providers that provide written verification of income for such purposes, which can also be an acceptable approach.

As a practical matter and given the relatively smaller exposure size of most consumer loans, it is not a common practice to verify employment in the manner described above for most consumer loans.

Calculating Income from W-2s The W-2 contains information on an employee’s earnings from a given employer in a calendar

year. For individuals primarily earning wage and salary income, the W-2 may have several advantages over the tax return or tax return transcripts when it comes to underwriting. First and foremost, the W-2 is reported for just one individual, while tax returns may be filed jointly for married couples. If an applicant is married but is applying for individual credit, a tax return will not provide enough information for you to differentiate that applicant’s income from his or her spouse’s income. Additionally, some of an individual’s income is not subject to federal income taxes and thus not reported on the tax return form 1040. For example, an applicant’s contributions to his or her 401k are pre-tax contributions, and thus the income listed on the tax return may not reflect the truest measure of an individual’s gross income.

The W-2 contains multiple pieces of information. Which piece is utilized in underwriting at your institution should be informed by your institution’s underwriting policies or procedures, and the information used should be utilized consistently for all applicants. If your primary interest is in obtaining the closest approximation of gross income possible (the nearest thing to the “top line” number on a paystub before any deductions), the proper place to look on the W-2 is Box 5 (Medicare wages and tips). Box 1 (Wages, tips, other compensation) does not include certain pre-tax deductions (such as 401k contributions), and thus will often be lower than Box 5 and not as close of an approximation of true gross income. Box 3 (Social security wages) is a measure of gross wages similar to Box 5, but is capped at the level of income that is subject to social security taxes ($118,500 in 2016), meaning that it will not reflect gross income for applicants who earn more than the cap in a given year. Note that all three of the boxes referenced above will exclude the portion of income paid toward health insurance premiums.



If your primary interest in using the W-2 is to corroborate information on the tax return or to measure income in the same way that it can be measured using a tax return, you will want to focus on Box 1. Box 1 on the W-2 is the figure that is translated to line 7 of the individual tax return form 1040.

Calculating Income from Paystubs In addition to W-2s and tax returns, paystubs should be collected and analyzed in

underwriting as well. They will typically provide the most current information about wage and salary income. W-2s are provided annually, around the end of January, while paystubs are available for even the most recently completed pay period. Paystubs also typically include more detail about the composition of earnings between base pay and any overtime, bonus, or commission pay. The most recently available paystub should be obtained, and it is recommended that the several most recent paystubs be obtained. This is because multiple paystubs can help clarify the frequency of pay and thus the length of the pay period as well as help provide a better indication of what a normal level of overtime pay, for example, may look like.

Though they are more current, paystubs do cover a shorter period of time than a W-2 or tax return. For this reason, both sources should be considered in the income calculation. W-2s and tax returns provide a longer time sample, while paystubs provide more current and detailed information. Underwriting should analyze both, and the underwriter should understand the reasons for any differences in the income calculation provided by each source. If an applicant did not work much overtime in the last two full years but shows a lot of overtime on the most recent pay stub, it would not be advised to consider that overtime to be stable, recurring income that can be counted on to repay the loan. However, if an applicant’s income as calculated from a paystub is higher than previous years’ W-2’s showed because of an increase in base pay (say, due to a promotion), it is reasonable to consider the new pay level to be indicative of stable, recurring income.

To accurately calculate monthly income from the paystub, the underwriter must know the time period covered by the paystub. Many paystubs will list the date range covered by the paystub (do not confuse this information with the date that the paystub was actually printed or the date the direct deposit made), but some may not. This is why multiple paystubs can be valuable. For example, a pay stub that says it is for the “pay period ending April 15, 2016” could represent a borrower who is paid every two weeks (representing pay for the weeks of April 4th and April 11th) or a borrower who is paid twice a month (representing pay for April 1st through April 15th). If the previous paystub is also obtained and says it is for the “pay period ending March 31st, 2016”, you will know that the borrower is paid twice a month rather than every two weeks.

The difference between being paid every two weeks and twice per month may seem small, but it can make a meaningful difference to the calculation of monthly income and thus to the DTI. The examples below show the difference, as well as provide examples of the type of calculation that needs to be done to obtain monthly income in each of these scenarios.



If the hypothetical applicant above has $2400 in monthly obligations, the difference between

the two calculations above is a DTI of 34% vs. a DTI of 37%, which can be the difference between qualifying and not qualifying under certain underwriting standards. For this reason, care must be taken in properly calculating monthly income from paystubs.

Sometimes, an underwriter may want to use a paystub’s year-to-date earnings information to calculate the applicant’s average monthly earnings over the year-to-date. This has the larger sample size advantage that W-2s have, but is more current, and might especially help if the borrower has consistently shown that bonus or overtime income will occur periodically throughout the year, but will not be consistent from one pay period to the next. Below is an example, using Excel, of annualizing year-to-date income and then turning it into a monthly figure. Underwriters can and do use other means for doing this calculation. This example is intended to show how it works conceptually and how Excel can be used to do it. Note that the calculation takes advantage of the fact that Excel treats dates as numbers, with each day being one number higher than the previous day, and as such dates can be subtracted from each other in Excel to identify the number of days that have elapsed between two dates.

This example was set up to show a borrower who happened to have a very stable income, being

paid $3250 per pay period and being paid twice per month. As you can see, in this example, the monthly pay calculation is consistent with the example above at roughly $6500 per month (this approach will not typically provide the exact same calculation as the approach shown above in scenario 2 given that the number of days in the year are not spread evenly across all 12 months or 24 pay periods, but it will provide a close approximation and is a valuable reasonableness check of calculations based off of a single paystub).

Gross Income on Paystub: $3,250Pay Frequency: Every 2 weeksPay Periods Per Year: 26Months in Year: 12Monthly Calculation: $3,250 * 26 / 12 =Monthly Income: $7,041.67

Scenario 1: Paid Every 2 WeeksGross Income on Paystub: $3,250Pay Frequency: Twice per MonthPay Periods Per Year: 24Months in Year: 12Monthly Calculation: $3,250 * 24 / 12 =Monthly Income: $6,500.00

Scenario 2: Paid Twice Per Month

Gross Year-to-Date Earnings:Date Range of PaystubEnding Date / As a Number: 7/15/2016 42,566End of Prior Year / As a Number 12/31/2015 42,369Number of Days Elapsed: 197

Annualization Factor:366/Days Elapsed 1.86

Annualized Pay:YTD Inc. * Ann. Factor $78,494.92

Monthly Pay:Ann. Pay / 12 $6,541.24

Scenario 3: Using Year-to-Date Income$42,250

July 1st - 15th



Calculating Income for Self-Employed Borrowers Calculating the income of a borrower who is self-employed could be a topic of its own day-long

training session, as there are a number of different possible scenarios. For the purposes of this fundamentals-based manual, we will provide some general guidance. First, the underwriter should always remember that the overarching principle of the income analysis is the same for self-employed borrowers as for wage earners: the goal is to identify and estimate stable, recurring income. Tax returns and tax return transcripts, as well as perhaps form 1099 (in some ways analogous to the W-2, this is the form provided to an individual to report “miscellaneous income” that they have earned, such as income from working as an independent contractor), will be relied upon more heavily.

For self-employed borrowers, knowledge of the various schedules that can be included with the individual 1040 tax return is helpful. For example, an individual who owns and operates a sole-proprietorship will report that business’s income on Schedule C. A farmer will report farming income on Schedule F.

The best advice to provide here for calculating income may be to rely on tools that already exist. For example, both Fannie Mae and Freddie Mac have forms available that can be used whether or not a loan is intended for sale on the secondary market. Fannie Mae Form 1084 and Freddie Mac Form 91 provide worksheets for entering in two years’ worth of income information. Both come with instructions. In practice, many loan origination software systems may have tools or calculators built into them to calculate self-employment income consistent with the GSE’s requirements. One tip for using such tools: it is helpful to keep nearby the instructions and a hard copy of the form, as this can help prevent one of the most common and easiest mistakes to make, which is to get confused about whether a certain line from the tax return should be entered as a positive or a negative number. The calculator will add some numbers and subtract others, which means the sign (+/-) that each figure should have may not always be intuitive.

Social Security Benefits and Grossing-up Non-taxable Income Social Security benefits are one type of income that an underwriter will see from time to time

that is not wage/salary or self-employed income. If an individual is receiving his or her own monthly retirement benefit, the amount of the benefit should be stable from month to month. In fact, this is one circumstance where using a deposit account statement evidencing direct deposits of Social Security benefits to verify income can be acceptable, since an individual’s own Social Security retirement benefits will not vary month to month and can be expected to continue. An award letter obtained from the Social Security Administration is another way to verify this income, and would be necessary for an applicant who may just be beginning to draw his or her benefit.

Social Security benefits are also the most common example of non-taxable income that may be shown by applicants. Child support is another example of non-taxable income that an underwriter may see. If your institution is doing its underwriting analysis on the basis of gross income, it is appropriate to “gross-up” non-taxable income to put it on the same footing as taxable income for the analysis. This should be done because, for example, $100 that is not subject to taxation is worth more than $100 that is subject to taxation. The non-taxed $100 will go farther towards paying debt and living expenses than will the $100 that will first have, say, $20 taken out of it for taxes. Thus, a standard approach to non-taxable income in underwriting is to multiply that income by 1.2 or 1.25 to “gross-up” the income and make it more comparable to taxable income for the purpose of the underwriting analysis. Of course, if your underwriting relies on an applicant’s net income rather than gross income, then you should not gross-up non-taxable income.



For social security benefits, some amount of the social security benefit can be taxable in some situations. Line 20a on the tax return shows the total amount of social security benefits received and line 20b shows the amount that was taxable. The difference would be the non-taxed amount, or the amount subject to grossing-up.

Credit Scores and Credit Reports

Credit reports are used in underwriting to help answer questions about both the applicant’s ability to repay (by providing and/or verifying the applicant’s level of monthly obligations) and the applicant’s willingness to repay (by providing information about the applicant’s past patterns of payment on credit obligations). However, underwriters should note that there are limits to the effectiveness or thoroughness of credit reports. Credit reports, after all, are only as accurate and comprehensive as the information reported to the credit reporting agency. For this reason, it is also important to review and understand an applicant’s performance history on any previous or existing loans with your institution. The manner in which they have handled any deposit accounts (are there frequent overdrafts?) can also be indicative of their financial management ability. This sort of in-house analysis will provide a more narrow review of past credit history than a credit report, but also a review in which you can have a high level of confidence in the accuracy of the information.

The Credit Score Credit scores are widely used in underwriting, but they may not always be widely understood.

For that reason, it is worth providing a brief overview of credit scores from a conceptual standpoint. In general, credit scores do a pretty effective job at identifying risk based on a borrower’s history. The credit score is essentially a summary of the borrower’s credit history and current credit position (for example, credit scores factor in the utilization rate, or how much of a borrower’s available revolving debt is currently being used). The goal of credit scoring is to order individuals from those least likely to default (high credit scores) to those most likely to default (low credit scores).

Underwriters should be aware, however, that one single credit score does not exist for any borrower. For one thing, there are three primary credit reporting agencies in the country: Equifax, Experian, and TransUnion. In addition to score differences that may arise from differences in the information obtained by each reporting agency, there are a number of different methodologies used to produce credit scores. Some methodologies have been developed to focus on risk for a specific type of lending (auto lending, for example, and such a score would not be appropriate to use for residential mortgage underwriting), while in other cases the most common or general methodologies are updated and refined over time. For example, FICO released FICO Score 9 in 2016, which made adjustments to the impact of collection accounts, particularly medical collections, on a consumer’s credit score. For loans being underwritten for the secondary market, Fannie Mae and Freddie Mac are specific about the version of the FICO score to be used. It is what they refer to as the “classic” FICO methodology. Depending on which credit reporting agency is providing the score, this will be the Equifax Beacon 5.0, Experian/Fair Isaac Risk Model v2, or the TransUnion FICO Risk Score 04. Because of this requirement, many institutions pull this credit score as a matter of course for all underwriting, even if the loan is not a secondary market residential mortgage. Underwriters should be sure that the credit scores referenced for underwriting are consistent across applicants and appropriate for the type of loan being underwritten.



A “tri-merge” credit report, in which a vendor merges the information maintained on a consumer by all three major reporting agencies into one report, is the most common type of report to use in residential mortgage underwriting. Such a report will result in three credit scores for the applicant, one provided from each reporting agency. In such a case, the standard practice is to base the underwriting decision on the median, or middle, score. For example, 720 is the median of 700, 730, and 720. If a score is reported more than once, that figure is the median. For example, if scores of 700, 710, and 700 are obtained, 700 is the median.

For many consumer loans, a credit report pulled from a single credit reporting agency rather than a tri-merge report is obtained.

The Credit Report The credit report provides more details and more information than can be obtained just by

looking at the credit score. The credit report gives you insights into the factors that contributed to the score, including the timing and severity of any payment delinquencies, the types of credit the applicant has and has not had historically, and any collections, judgments, or liens against the applicant and whether they have been satisfied. Generally speaking, every loan request should be supported by a newly-pulled credit report. A new credit report must be ordered for every residential mortgage loan being underwritten, both for safety and soundness considerations and for compliance with the ATR rule.

In reviewing the credit report, the following are some of the things the underwriter will need to do to ensure an accurate and consistent underwriting analysis:

• For joint applicants for credit, appropriately identify any existing joint credit so that it is not double-counted (this is especially important if individual credit reports rather than joint reports are pulled)

• Differentiate leases from installment debt • Identify the amount of time remaining on installment debts, if the institution’s approach

to underwriting ignores debts that are soon to pay in full • Differentiate charge cards from credit cards • Identify the type, status, and number of any collections, judgments, or liens • Note the applicant’s utilization rate on available revolving credit. High utilization of

revolving credit (for example, the applicant’s balance on all three of his or her credit cards is near the maximum credit available) is a sign of increased risk. It indicates that the borrower has been utilizing credit (in the case of credit cards, this usually means expensive credit) to make ends meet. This sometimes is the result of unavoidable adverse circumstances (for example, significant unforeseen medical expenses), but can also often be the result of poor financial management. In addition, a high utilization rate means that an applicant likely doesn’t have much room to use credit to get by if any more unforeseen adverse events occur. The utilization rate is factored into the credit score.

• Identify recent inquiries from other lenders. The underwriter needs to be sure that these inquiries did not result in additional credit, and thus additional monthly obligations, that are not yet reported on the credit report.

• Compare the debts on the credit report to the debts listed on the application. Not all creditors report data to the reporting agencies, and errors do occur. If there is debt on the application that is not on the credit report, the underwriter needs to work with the applicant to verify the payment amount and any other relevant terms. This is one reason why an application that is filled out completely is important.



Collateral Analysis As mentioned above, collateral will typically be the secondary source of repayment for a

consumer loan or residential mortgage. An institution’s credit policy should provide guidelines regarding the types of collateral that are acceptable, how values for different types of collateral should be obtained, what acceptable advance rates against collateral are (that is to say, what the maximum acceptable LTV for a given kind of collateral is), and how long of an amortization a loan secured by a given type of collateral may have.

The underwriter needs to obtain enough information on the proposed collateral to allow for an appropriate estimate of the value of the collateral to be obtained, consistent with the institution’s policy. For example, for a used car loan you will need to know the year, make, model, mileage, condition (ideally via an inspection) and any features or add-ons.

Important considerations in assessing collateral include the market value of the collateral, the anticipated useful life of the collateral and how quickly its value will depreciate, the marketability of the collateral, and the ease of recovering the collateral in the event of a default. Loans should be structured so that the amortization of the loan generally matches the depreciation of the collateral, which can help maintain the appropriate collateral margin throughout the life of the loan.

How a piece of collateral is valued will vary widely by the type of the collateral. Real estate should be appraised (in special cases an evaluation may be used) in accordance with an institution’s policies and the Interagency Appraisal and Evaluation Guidelines from December 2010. Important points to remember about an appraisal program include the importance of independence in the ordering and review of appraisals and the need for effective appraisal reviews produced by qualified and independent individuals. For new vehicles, many institutions base their LTV calculations on the invoice price of the vehicle. Some lenders will also finance sales tax and such additional expenses as Gap Insurance or warranties. It is important to recognize how financing such add-ons may impact the loan amount in comparison to the recovery value of the vehicle. Used vehicles are more likely to be valued using a used vehicle price guide, such as those produced by the NADA or Kelley Blue Book. For used vehicles, policy or procedures should be clear regarding which of the several provided values (i.e., Clean Retail, Average Trade-In, etc.) is to be used. Physical inspections of used vehicles are a good idea and can inform this decision.

A Note on the Loan-to-Value Calculation for Real Estate Loans

Calculating a loan-to-value is a simple exercise, of course: simply divide the loan amount by the property’s value. Underwriters should keep in mind, however, that for loans secured by real estate, the LTV calculation should consider both the appraised value of the property and, for purchase transactions, the purchase price. The appropriate LTV to consider for underwriting purposes is the higher LTV from these two calculations or, in other words, the LTV obtained using the lesser of the appraised value or purchase price.

More important than the simple calculation of LTV, however, is to understand the information that the LTV does and does not convey. Most importantly, an acceptable LTV at origination (say, of 80%) does not mean that there is no chance that the lender will realize a loss on the loan eventually. The value in the LTV calculation is a reflection of the market value at the time the valuation is obtained, and market values can and sometimes do decline. Even more commonly, the condition of the property will change between the time the valuation is obtained for underwriting and the time that the collateral may be liquidated after a default. Borrowers who



know they will be losing their home have less incentive to properly maintain their home, and on some occasions may even damage the property intentionally. Thus, the recovery value when a property is eventually liquidated may fall short of the value at origination. Requiring appropriate LTV margins at origination is one way to mitigate this risk to some extent. Like with other requirements it can be appropriate to consider the LTV in the context of other risk factors. A higher LTV could mean a higher loss if a borrower defaults, but if a borrower appears to be a very low risk of default, then the credit may still be an appropriate risk for your institution.

One final note is that, though we have primarily discussed collateral as impacting the secondary source of repayment, the collateral position can also have an impact on the primary source of repayment by impacting the willingness of the borrower to repay. Borrowers without any equity in their home have less incentive to make timely payments than do borrowers with significant equity in their homes, because they have no equity to lose if they do lose the home. Many borrowers take debt obligations seriously and will make payments even if they are underwater on their home (the loan amount exceeds the home’s current value), but historical experience across the industry has shown that loans with higher LTVs are at a higher risk of default, and part of that can be attributed to a greater willingness of borrowers to walk away from a property if they do not have any equity in it.

The Applicant’s Balance Sheet

For many consumer loans, underwriting is appropriately focused primarily on the repayment ability and credit history of the applicant and on an evaluation of the collateral. However, for residential mortgage underwriting, it is also appropriate to consider the balance sheet, or the liquidity and financial reserves, of the applicant.

Residential mortgage underwriting can make use of an analysis of reserves to quantify an applicant’s liquidity or reserves. For residential mortgages, the reserves calculation is performed by taking the liquid assets an applicant will have after the loan closes (that is, after all cash that will be due from the borrower at closing has been paid) and dividing it by the monthly housing payment (PITI). The result is the number of months of housing payments the applicant could make from their liquid assets. Of course, if all other income were to cease the applicants would have to do more than just make their housing payment (they’d have to buy food with their liquidity, for example), but this is the convention for calculating liquidity. Liquid assets refers to cash (typically documented with deposit account statements, which in many cases may be held with your institution) and things that can quickly be converted to cash, such as marketable securities.

The number of months’ worth of reserves that should be required, like everything else in underwriting, depends in turn on other risk factors. The value of some liquidity on the part of the applicant, however, is clear. A reasonable level of liquidity means that the applicant will have the ability to withstand an adverse event (say, unforeseen medical expenses) or temporary interruption in income (say, a lay-off or a short-term leave with disability insurance that covers only a portion of the applicant’s standard earnings) without falling behind on debt. An adequate level of reserves can also be a sign that an applicant has good financial management skills.



Note on the Source of Down Payment Funds for Residential Mortgages One additional consideration for residential mortgage underwriting concerns the down

payment, and particularly the source of the funds to be used by the applicant to make the down payment. The primary concern of the underwriter with respect to the down payment funds should be to document the source of the down payment to make sure that the funds for the down payment were not borrowed, as doing so would reduce the applicant’s equity in the property (and thus reduce the incentive to make the loan payments) while also increasing monthly obligations and impacting the ability to make all debt payments. The means undertaken to verify the source of the down payment can vary. Often, several account statements (of savings or investment accounts) are obtained to show that the applicant has saved the funds. If the funds are a gift from a family member, a letter can be provided documenting that the funds are a gift and that no repayment is required.

Documenting the Underwriting Analysis Effectively

This manual has already discussed the necessity of clearly and consistently documenting the underwriting analysis that is performed. For consumer loans and residential mortgages, we will use the term “underwriting sheet” to refer to the summary document that should be used for this purpose. Such a document need not be long and can be effectively designed in any number of ways. Different underwriting sheets may be used to support the underwriting of different types of credits, but an institution should be consistent in using the same forms and in filling them out completely across all underwriters. Generally, effective underwriting sheets should have the following basic characteristics:

• The sheet should summarize the proposed transaction: who the borrower(s) is (are); what the loan amount, interest rate, amortization, payment amount, payment schedule, and term are; and what the collateral is.

• The form should clearly list the income (for example, “salary”) used in underwriting, the source used to verify that income (for example, “paystubs and tax returns”) and the calculation performed to calculate the monthly or annual income (for example, “borrower receives salary income only, has maintained steady employment, so figure used in DTI calculation is most recent month’s income from paystubs in file”) for all borrowers on the credit.

• The monthly obligation information used should be itemized on the form. If the applicant does not have housing expenses for some reason, document that clearly. If debts on the credit report or application are being paid-off or refinanced and thus excluded from the calculation, make sure that is clearly noted.

• The income and monthly obligation information should be added up and then divided for the ratio analysis. Using an automated form with proper controls can make the math more efficient and less prone to error.

• The source of the collateral valuation, the collateral value, and the LTV should be clearly shown.

• The applicant’s credit score should be displayed. Relevant notes about the institution’s historical experience with the applicant should be provided. The applicant’s explanations for any derogatory items on the credit report may also be discussed.



• Any policy exceptions for the credit should be clearly identified, as should the justification for the exception. Appropriate approval authority should be indicated.

• Often, for consumer and residential underwriting, it is appropriate to indicate on the underwriting sheet what the credit decision is as well as the approving authority that approved that decision. As appropriate, any other narrative explanation needed to clearly explain the credit decision should be provided.

Above all, the underwriting sheet should provide enough information and enough detail to allow someone reviewing the underwriting to independently verify all components of the underwriting.


Section 4: Underwriting Commercial Loans

The underwriting of commercial loans tends to be an even more detailed and less homogenous process than the underwriting of consumer loans or residential mortgages. This section is intended to provide a simple overview of some of the critical concepts of commercial underwriting. Further training, ideally specific to the kind of commercial loans an analyst will be expected to underwrite, can build off of this foundation.

Sources of Repayment

Because the sources of repayment can be much more varied for various types of commercial loans, it is even more critical that underwriting of commercial loans begin with a thorough understanding and documentation of the sources of repayment.

The most common primary source of repayment for commercial loans is the cash flow generated by the operation of the business. This could be the rental cash flow from a commercial real estate property, the cash flow generated by the operation of a pizza shop, or the cash flow generated by a grain farming operation, among many possible examples. In many other cases, a credit facility may be financing working capital for a borrower, and the primary source of repayment may be the conversion of current assets (such as accounts receivable) into cash.

The most common secondary source of repayment is the support of individual guarantors and/or other entities related to the borrower. Many commercial loans will be structured to include the financial guaranty of the principals of the business and/or of related businesses. If the primary borrower does not have the financial capacity to repay the loan as agreed, the secondary source of repayment may be cash provided by the guarantor or related company. Such support may come out of liquid assets or excess cash flow of the related entity. A third, or tertiary, source of repayment for collateralized business loans is the liquidation of the collateral.

Understanding the sources of repayment is critical as it informs both where the underwriter looks to verify the ability and willingness to repay and how the credit should be structured. For example, most loans to grain farmers are structured to have one annual payment since the farmer receives most of his or her annual income only upon the sale of grain after harvest. Alternatively, a loan to a dental practice would typically require monthly payments, since a dentist’s cash flow should not be expected to be seasonal.

Applications and Information to Gather

The initial inquiry stage for commercial loans is often not as structured as it is for consumer loans or residential mortgages, but it is arguably more important. This is, again, because commercial loans tend to be less homogenous than consumer loans. Though institutions should still have clear policies around acceptable structures for business credits, it will usually take more analysis and understanding of the potential borrower’s business to ensure that the loan is structured in a way that protects the lending institution and meets the needs and repayment capabilities of the borrower.

Though requests for commercial credit are often not as simple as a borrower walking in the door and saying, “I want to apply for a loan,” it is recommended that all commercial borrowers fill out a written application. The application should state the purpose of the proposed credit



(including an indication that it is a business-purpose credit, which documents that the application and subsequent loan are not subject to certain compliance requirements), the requested terms and dollar amount, the proposed sources of repayment, the type of collateral offered, and should indicate the intent to apply for joint credit (if there is in fact such intent).

Commercial lending can involve obtaining the obligations of people, corporations, partnerships, and a host of other legal entities. One crucial feature of underwriting is to ensure that the appropriate parties are obligated on the credit, either as borrowers/co-borrowers or guarantors.

The legal details of various structures for organizing business entities can be reserved for more advanced training. For the purposes of this manual, it is important that the lender and underwriter understand the ownership structure of any business entities and understand what entities or individuals own the business assets, particularly any assets being pledged as collateral. It is also important to understand, before closing, what documents and signatures are required for a business entity to be legally authorized to enter into a loan. A good—and common—practice is to require all significant owners of a business (often defined as owners with more than a 10-20% stake) to individually guaranty the business credit. Some important information to collect related to these factors includes:

• An overview of the ownership of all legal entities and of all business assets • Organizational documents of legal entities (partnership agreement, articles of

incorporation, corporate by-laws, operating agreements, etc.)

• Borrowing resolution • Certificate of Good Standing

Assessing the Capacity to Repay

The measure of repayment capacity most commonly used to evaluate requests for commercial credit is the debt service coverage ratio (DSCR). Just like DTI, calculating the DSCR is simple in theory. The DSCR simply represents the ratio of cash flow available to service debt to the required debt service. That is, it can be calculated as cash flow divided by debt service. Numbers above 1.00 indicate that the cash flow generated in a time period exceeds the debt payments required in that time period. Many institutions place the minimum acceptable DSCR in the 1.20-1.25 range, though like with DTI the details of the methodology used to calculate the DSCR have a significant impact on what level might be considered acceptable. Typically, the DSCR of the primary borrowing entity will provide an estimate of the capacity to repay the debt from the primary source of repayment. A global DSCR, which includes the cash flow and debts of the individual guarantor(s) and other related entities, is often an estimate of the capacity to repay the debt from the secondary source of repayment. Prudent underwriting should analyze both the primary borrower’s capacity to repay and the global cash flow.

There are two basic approaches to calculating cash flow, both of which are discussed briefly below. Note that there is much room for nuance and variation in calculation within the first approach:

• The “traditional” cash flow approach. The “traditional” approach to calculating a business’s cash flow starts with net income and adds back interest and other non-cash expenses such as depreciation and amortization. The traditional approach includes methods such as



EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIDA (Earnings Before Interest, Depreciation, and Amortization). The approach attempts to estimate the cash generated by the business by starting with any net profit or loss and then adding back those expenses, such as depreciation, which did not represent an actual outlay of cash. Interest expense is added back as it is included in the required debt service payments in the denominator of the calculation.

Though there are many nuances to this approach, the traditional cash flow can be fairly quick to calculate and relatively easy to understand. It generally works well for evaluating non-owner occupied commercial real estate loans for which rental income is the primary source of repayment, and will be adequate for many other scenarios as long as there are not significant changes in the borrower’s balance sheet or operating cycle.

• The Uniform Credit Analysis (UCA) approach. The UCA approach to calculating cash flow looks at not only the income statement but also the balance sheet at the beginning and ending dates of the time period covered by the income statement in order to calculate the cash available to service debt. This method more completely measures available cash by considering changes in balance sheet composition in addition to those items on the income statement, such as net income, which may represent cash flow generation. For example, consider a business which recognized $300,000 in net income in a year based on $900,000 of sales, but only collected $400,000 of cash for those sales, with the other $500,000 representing as-yet-unpaid receivables. The traditional cash flow approach would not distinguish this business from one which collected all $900,000 of its sales in cash, while the UCA approach would take into account the change in the balance sheets (which likely include an increase in accounts receivable and a decrease in cash for the first business) in recognizing that the two businesses had different levels of cash available to service debt.

The UCA approach requires more complete financial information than the traditional approach, and will be less transparent to many lenders who are more familiar with the traditional approach. It requires more intense calculation, although most current financial analysis software packages have the ability to calculate a UCA cash flow based on the financial information entered by the analyst. The UCA approach is most advantageous for commercial and industrial credits and in scenarios where there are significant changes from period to period in the composition of a business’s balance sheet.

The denominator of the DSCR calculation should be the borrower’s required debt service for the period being analyzed. Like in the DTI calculation, this should include debt service payments on the proposed debt, and should exclude payments on debt to be paid off or refinanced. It is important to include the proposed debt because the purpose of the calculation is to assess the borrowing entity’s capacity to repay its debt going forward. However, the analyst should be aware that growing companies that are adding assets that are expected to generate additional revenue (for example, think of a trucking company that is adding more trucks and trailers) may not demonstrate historical cash flow sufficient to cover proposed increases in debt service levels. In such situations, determining likely repayment capacity will depend on an analysis of reasonable financial projections and an assessment of the abilities of management to make wise decisions regarding investment in new assets and to implement the new assets effectively.



A Note on Financial Information Needs for Commercial Loans As with consumer loans and residential mortgages, the amount and type of information needed

to calculate and verify repayment capacity will vary by the scenario. The number of possible documents to request, however, is greater. Below is a summary of some common information to request:

Individual Borrower or Guarantor • Personal Financial Statement (PFS)

o The PFS should be completely filled out and should be signed and dated. It should include all contingent liabilities of the individual and supporting schedules (such as of real estate owned, marketable securities accounts, etc.) should be completed. If a PFS is joint with someone who is not a joint applicant on the credit, the PFS should indicate which assets are owned jointly and which are owned by one individual or the other.

• Personal Tax Return

o The tax return should include all relevant schedules and statements, including copies of Schedule K-1 from business interests, if applicable. Generally, at least three years of returns should be obtained.

• Rent Roll

o If the individual owns rental properties, a rent roll showing the occupancy status of the units or properties, the terms of the leases in place, and the lease expiration dates should be obtained. In many cases, copies of the leases should also be obtained for the credit file.

Corporations and Partnerships • Tax Return

o The tax return should include all relevant schedules and statements, including Schedule K-1 if applicable. Generally, at least three years of returns should be obtained if possible.

• Accountant-Prepared Financial Statements o If the entity has audited, reviewed, or compiled financial statements prepared by an

accountant, those statements should be obtained. For borrowing entities of significant size or in certain industries, a lender may choose to require audited or reviewed statements. Generally, at least three years of statements should be obtained if possible.

• Interim Financial Statements o If a meaningful period of time has elapsed since the end of the period shown in the tax

returns or accountant-prepared statements, an interim balance sheet, income statement, and statement of changes in equity should be obtained from the borrowing entity. Officers and analysts should keep in mind the possible limitations of interim, borrower-prepared financials.



• Rent Roll o If the entity owns rental properties, a rent roll showing the occupancy status of the units

or properties, the terms of the leases in place, and the lease expiration dates should be obtained. In many cases, copies of the leases should also be obtained for the credit file.

• Debt Schedule o If not contained in accountant-prepared financials, a complete listing of the entity’s

debt, including the terms, maturity, and collateral securing each debt, should be obtained.

• Schedule of Furniture, Fixtures, and Equipment o If relevant to the credit, a listing of the borrower’s equipment, including accumulated

depreciation, should be obtained. • Accounts Receivable and Accounts Payable Aging

o If relevant to the credit, a schedule of the entity’s receivables and payables, showing the counterparty and delinquency status, should be obtained.

• Inventory Schedule o If relevant to the credit, a schedule detailing the composition of the entity’s inventory

should be obtained. • Business Plan/Financial Projections

o Especially for start-up or growing businesses, the lender should obtain a business plan and any financial projections produced by the borrower

Nonprofits • Financial Statements

o A balance sheet and a change in net assets statement (comparable to an income statement) should be obtained, generally for at least the past three years. Depending on the size and nature of the borrower, the lender may require these to be audited or reviewed statements. The balance sheet should provide detail on restricted and unrestricted assets and the terms of the entity’s existing debt should be disclosed.

o Occasionally, IRS Form 990 (the form for organizations exempt from income taxes) may also be required.

• Membership/Attendance/Giving Information o For religious organizations, information on attendance and membership levels, as well

as the number of giving units, can provide additional information about the prospects of the organization to fund its expenses and debt service.

Assessing the Business’s Balance Sheet In commercial underwriting, it is not enough to simply assess a potential borrower’s income

statement or cash flow. An analysis of the borrower’s balance sheet is also critical to understanding the financial situation and repayment prospects of the business. There are several factors that should be analyzed with respect to a business’s balance sheet. Benchmark figures for the various measures are difficult to provide, since the standards can vary significantly by industry. The Risk Management Association publishes some information that provides a summary of balance sheet measures by industry, and some financial spreading software packages also collect data and provide comparative figures on an industry basis.



Leverage refers to the ratio of a business’s debt to its equity capital (or net worth). A better-capitalized business will be more resilient to downturns and setbacks, and also may be more able to take advantage of growth opportunities. The standard measure of capitalization is the leverage, or debt-to-worth, ratio, calculated as total liabilities divided by net worth. An alternative measure, which in some cases will provide a more reliable figure, is the debt-to-tangible-net-worth ratio, which is calculated the same as above but removes intangible assets from the calculation of net worth. It can also be appropriate to distinguish external debt (such as that owed to financial institutions) from shareholder debt, which represents funds lent to the business by the owners. Shareholder debt can at times be subordinate to external debt and may in practice function more like equity than like debt. Whatever measure is used to estimate leverage, it can be said that, all else equal, the more leveraged a business is, the harder it will be for it to borrow additional funds in times of need or to weather a down year by absorbing losses with its capital account.

Liquidity is another very important balance sheet factor. Low leverage is great, but if all of a business’s assets are tied up in illiquid assets, the ability to make debt payments and pay other expenses if cash flow slows may be in doubt. Liquidity can be measured in several ways. Two of the most common are the current and quick ratios. The current ratio is calculated as current assets divided by current liabilities, while the quick ratio is calculated similarly except that inventories are excluded from current assets. Just like with DSCR, the trends in the leverage and liquidity ratios should be noted in addition to their absolute levels.

A related issue is the analysis of the borrower’s working capital. Working capital refers to the capital needed to fund operations because costs of production are incurred before cash related to that production is received. Net working capital is calculated as current assets minus current liabilities. Evaluating a business’s working capital involves understanding its funding structure (the mix of short- and long-term liabilities and equity that fund its assets). The amount of time it takes for accounts receivable to be collected and accounts payable to be paid is an important factor in determining working capital needs.

Assessing the Abilities of Management

An assessment of the management ability of the borrower is crucial to understanding whether a borrower will have the ability to repay its debt in the future. It is undeniable that the skills of management play a huge role in the eventual success or failure of a small business. While management ability is not always easy to assess, especially for a start-up business, there are certain indicators that can help provide some insight. These include:

• Experience in the industry or similar industries, especially whether or not management has previously demonstrated the ability to run a successful business.

• Succession planning. Is there a plan in place to ensure competent management is in place when the current management retires, or if health or other considerations force current management to step back from the day-to-day management of the business? If not, additional protection, such as an assignment of a life insurance policy, may be in order.

• On-site visits. A visit to the business’s facility can provide a great deal of insight into the nature of the operations. Are the facilities orderly, without obvious deferred maintenance? Is equipment kept in good working order? Do operations appear to run smoothly?

• Quality of financial reporting and record keeping. Good management will have reliable and consistent financial reporting and record keeping practices. This in turn can help the lender feel comfortable that it will receive the information necessary to evaluate and



monitor the credit, and can ensure that management has good information for making decisions regarding the operation of the business.

• Employee turnover. A business with high employee turnover may not have the continuity necessary for successful operations; further, such turnover may be a sign that management is difficult to work with.

• Industry knowledge and participation. Leadership in trade groups, lobbying activities, or other industry participation outside of their own business may indicate that management is knowledgeable and committed to its business.

• Thoroughness and reasonableness of the borrower’s business plan.

Collateral

Collateral plays a critical role in prudent commercial lending just as it does in prudent consumer or residential mortgage lending, as it provides the fallback source of repayment if other sources prove inadequate. The basic considerations that apply to collateral for consumer loans and residential mortgages apply to commercial collateral too. A proper independent valuation is necessary. Even more than for most consumer loans or residential mortgages, consideration must be given to the marketability, useful life, and ease of recovery of the collateral.

For commercial real estate, the increased size and complexity of many properties and thus of the appraisals valuing them means that an even more detailed appraisal management and appraisal review process is necessary to ensure that proper real estate valuation processes are followed.

Some commercial loans, especially revolving lines of credit, may be secured by inventory and/or accounts receivable. It is important that the underwriter understand some details about the available collateral and how those details may affect recoverability. For example, a prudent policy is to avoid attributing any value to severely delinquent accounts receivable (often, even current receivables associated with a payer with a seriously delinquent receivable are disregarded, which is referred to as a “taint rule”), and to monitor and perhaps limit the extent to which the institution allows itself to advance against receivables that are concentrated with one payer. With inventory, it is important to differentiate between raw materials, work-in-process (which typically has the least recovery value and may require additional costs to be incurred before it is salable), and finished goods. It can also be beneficial to be aware of accounts payable owed by your borrower, as a supplier may have a superior claim on inventory if they have not been paid for the materials by your borrower.

Documenting the Underwriting Effectively

On the commercial lending side, the documentation of the underwriting is typically accomplished with a document referred to as a loan or credit presentation. Effective credit presentations typically begin by describing the structure of the proposed transaction and describing the basics of the borrower’s business, history, and the proposed deal. It is advisable to provide an overview of the borrower’s full depository and borrowing relationship with your institution and the aggregate exposure to the borrower, guarantor, and related entities. It is important that key numbers, tables, and financial spreads and ratios, as well as a narrative discussion of all aspects of the underwriting, are included. Though this webinar does not address



risk rating credits, it is appropriate that credit presentations assign a risk rating to the proposed credit. Finally, the loan presentation should result in a summary of the credit’s strengths and weaknesses or risks and mitigating factors. Often, the presentation should conclude with a recommendation for the loan committee of how to proceed with the credit.

Conclusion This manual and the accompanying webinar sought to provide an overview of some critical

basic and fundamental principles of credit underwriting, while also mixing in some applied discussion of how to handle certain scenarios, what information the underwriter should obtain, and how to remain compliant with some significant aspects of fair lending laws. The information provided here should be applied to underwriting credit at your institution in a manner that is consistent with the policies and procedures of your institution.

Documents

Loan Underwriting Basics: Interviewing, Credit Reports ...Loan underwriting is both a broad and a deep topic. For the purposes of this manual and the associated webinar, for which