There are numerous processes needed before a loan is authorised when you apply for one. This is due to the fact that lending institutions take some risk when making loans. Lenders evaluate the risk of granting you the loan based on a number of criteria to determine how much is to be given to you. The underwriting of loans is the process in question. You will comprehend the definition of loan underwriting and the contributing variables in this text.
What is Loan Underwriting?
Loan underwriting is a step in the loan approval process where the lender evaluates your creditworthiness. The lender will verify your income, debt, assets, etc to assess whether you meet their eligibility criteria. This underwriting process aims to minimize the lender’s risk by ensuring that loans are granted to individuals or businesses who are highly likely to repay. Essentially, underwriting is for the lender to gauge the amount of risk they should take in exchange for a premium, which is the interest rate.
Speaking of the Personal Loan underwriting process in particular, the definition is same as of other kinds of loans. However, the processes involved in it can differ slightly.
Different Types of Loan Underwriting
Automated Underwriting
Automated underwriting is a technology-driven process that uses pre-designed computer programs (also known as Automated Underwriting Engines) to evaluate your loan applications. The system automatically generates underwriting based on information such as income, collateral value, and debt entered the system, which reduces the need for manual review.
As an algorithm-driven process, it is free of human error. Also, unlike a manual underwriting process that can take days or even weeks, automated underwriting can even determine your eligibility for a loan in a few minutes. Many leading NBFCs have integrated this technology into their Personal Loan underwriting process too.
Manual Underwriting
While it is slower than automated underwriting, manual underwriting is useful for borrowers who have unique or complex financial situations and are likely to be rejected by the automated process. The human approach that comes with manual underwriting can help in the following conditions:
- You have little to no credit history.
- Your debt-to-income ratio is high.
- You have had financial difficulties in the past.
- Rules of Loan Underwriting
- Underwriting rules or standards are specific guidelines set forth by lending institutions for determining your creditworthiness. Here are some of the underwriting criteria for loans that are considered:
Credit Score
Your credit score is one of the most crucial factors influencing your loan approval since it determines if you are reliable in paying on credit. A credit score represents how prudent you have been in repaying your past loans. A credit score of 750 or above gives you a higher chance of loan approval. As you are perceived as a low-risk borrower, the lender may also give you a higher loan amount with more favourable terms.
Income
Income refers to both gross (the amount a person earns after tax deductions) and net income. Most lenders have an income bracket below which they usually do not lend since they believe that a borrower’s income cannot cover the monthly payments for a loan. They will also check your bank statements to ensure there is no income gap. Moreover, if you have multiple sources of income, make sure to mention that as well. Individuals with higher incomes have more chances of getting loan approvals.
Debt and Liabilities
Your current level of debt and liabilities significantly impacts your loan repayment ability. So, the lenders investigate the amount of debt you have, to check if you can afford to pay back the loan. Your Debt-to-Income Ratio (DTR) becomes an important factor here, which shows how much of your income is spent on paying off your debt. Having a DTI ratio of under 30% is ideal.
Collateral Value
Secured loans, such as home loans and car loans, requires you to pledge an asset as collateral. Keep in mind that if your collateral is in poor condition, your loan application may be rejected. So, your collateral value should either be equal to or more than the amount you are applying for. Providing collateral also means you get a higher loan amount at lower interest rates as it is a low-risk loan for the lender.
What are the Steps Involved in Loan Underwriting?
The process of loan underwriting depends on the type of loan. Here are the general steps involved after you submit a loan application:
- Income Review: The lender reviews your income, the length of your employment, and if there are any gaps in it.
- Debts and Liabilities: The lender checks your debts and liabilities and accesses your credit score and report. Any defaults on payment will make a significant impact on your credit score.
- Collateral Evaluation: For secured loans, the lender reviews the collateral to ensure its value is sufficient to secure the loan amount. In the case of home loans, the lender does a property appraisal to ensure your property’s value is around the same as similar properties.
- Satisfying Additional Conditions: While the underwriting process happens behind the scenes, you may still have to be available when lenders ask you for additional documents and questions.
- Risk Assessment: After gathering, evaluating, and assessing the above information, the lender assesses the overall risk associated with the loan. Based on this, the lender determines if the risk level is acceptable and aligns with its conditions.
- Finalising the Loan: If your loan is approved, the underwriter works with the loan processes to prepare the final loan and get all the necessary documents in order.
Conclusion
Underwriting is the process of assessing creditworthiness and understanding if the borrower will be able to repay the loan. Depending on the type of loan you are applying for, the process can take either a few minutes or a few days. To ensure a smooth underwriting process, get all your documents in order, avoid applying for loans from multiple lenders, and boost your creditworthiness.
Frequently Asked Questions
What are the 4 Cs of loan underwriting?
The 4 Cs or components of loan underwriting are capacity, capital, collateral, and credit. Capacity to repay the loan, capital that you can convert to cash, collateral to pledge as security, and credit score and history to assess your creditworthiness.
Why do you need loan underwriting?
Loan underwriting is needed for lenders to assess the risk involved in providing a loan. Through this process, lenders do a thorough check of your financial condition to verify if you will be able to repay the loan.
How do banks underwrite loans?
Banks or financial institutions usually have financial analysts or hire underwriters to assess the risk involved in approving the loan and the creditworthiness of the borrower. The underwriter applies the lender’s conditions and the underwriting rules to the borrower’s loan application.
