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October 28, 2012

Where the term ‘underwriting’ comes from

October 28, 2012

Where the term ‘underwriting’ comes from

Doing my required annual continuing education for lender licensing today, and so far this is one of the more interesting things that I’ve read: the origin of the term ‘underwriting’. Excerpting it below and also throwing in some basic descriptions of underwriting for consumers who may not know.

According to the United States Department of Housing and Urban Development (HUD), underwriting is “the process of analyzing a loan application to determine the amount of risk involved in making the loan; it includes a review of the potential borrower’s credit history and a judgment of the property value.”

The term underwriting is believed to have been coined by the famed insurer Lloyd’s of London which, in its early days, would accept some of an event’s risk in exchange for a premium (for example, a sea voyage that features the possibility of a shipwreck and the subsequent loss of cargo and/or even the crewmembers). The individuals paying the premiums would literally write their names under the text describing the possession or event for which Lloyd’s was assuming some risk; hence, the term written under or underwriting.

So, what is the underwriting process? To understand the complex process of underwriting a mortgage loan, it is best to start with an understanding of the considerations and aspects of underwriting a loan. Loan underwriting guidelines provided by the institutions that will keep or obtain a loan are based on the following criteria:

Income: An important consideration during the loan underwriting process is the income of the borrower. The ultimate loan payment is calculated based on the income of the borrower; the size of the loan and the down payment required are also decided based on the income of the borrower.

Debt-to-income ratio: This is the ratio between the borrower’s monthly payable debts and the monthly income. The debt-to-income sometimes is calculated for the entire year. The reason for calculating this ratio is that it allows the underwriter to insure payment of outstanding debts, along with the introduction of a potential mortgage loan payment, based on available income.

Employment and source(s) of income: An important aspect considered by underwriters is the employment status of the borrower and the source of the borrower’s income. Underwriters analyze the length and term of employment and the status of the employment relationship and determine whether other income (such as second jobs, bonuses, or overtime pay) is eligible to use in underwriting.

Credit report: For an underwriter, a borrower’s credit report holds two important pieces of information: the credit history and the credit score. The history is a record of all the borrower’s previous credit-related activities. The score is based on proprietary formulas used by each of the three major credit bureaus. Each bureau uses a different formula that nets a different (though usually similar) score. A credit score is calculated on the basis of payments, types of credit, balances of credit, how long the borrower has had credit, and defaults (such as bankruptcies and foreclosures).

Value of the property: The value of the property is also considered by the underwriters in real estate transactions. The underwriter must base the amount that the borrower is eligible to borrow on the appraised value of the property (or the purchase price, whichever may be less.)