Underwriting, as a general practice, is the assessment of risk. According to Wikipedia, mortgage underwriting is “the process a lender uses to determine if the risk of offering a mortgage loan to a particular borrower is acceptable.”
What, exactly, that means in the traditional mortgage industry is primarily determined by Freddie Mac and Fannie Mae. As the federal entities behind the millions of mortgages securitized and sold every year across the capital markets, Freddie and Fannie’s obligation is to ensure loan risk profiles meet investor expectations. They accomplish this by requiring traditional mortgage lenders to adhere to strict sets of underwriting guidelines.
The same, basic principles of risk management apply in the world of Non-QM mortgage lending. As with traditional mortgage lending, the goal of every loan is to lend responsibly. After all, whether you’re the homebuyer, the lender or the investor, the performance of the loan depends on minimizing risk to optimize financial return.
To achieve this, both traditional and Non-QM mortgage lending apply the 3 C’s of underwriting: credit, capacity and collateral.
During the credit evaluation process, an underwriter reviews the borrower’s credit history including their repayment record for prior and current debt obligations such as car loans, student loans and credit cards. If the applicants are first-time homebuyers, they will also check to see if they have a history of paying their rent on time.
Next comes ‘capacity’, a.k.a. the borrower’s financial capacity to repay the mortgage. This entails a comprehensive assessment of the borrower’s income and debt obligations such as current loans, credit card balances, alimony and child support payments. By comparing the amount of a borrower’s monthly debt against their monthly income, underwriters can calculate the borrower’s DTI or debt-to-income ratio: a key underwriting determinant of loan affordability. The general target DTI for traditional mortgages is 43%. In Non-QM, it’s a little higher at 50%. ‘Collateral’ refers to the property being purchased. Underwriters will use an appraisal to ensure that should the borrower default, the value of the home is enough to cover the loan amount and protect them from a loss.
So, what is the most important difference between traditional mortgage underwriting and Non-QM mortgage underwriting? It’s in the income verification process. Traditional lenders are required by the GSEs to use a borrower’s W2 to determine income and loan affordability. Non-QM providers, on the other hand, can use alternative documentation to verify income. Furthermore, they can also take into account the borrower’s entire financial picture and status. For income verification, Non-QM lenders typically require 12 or 24 months of the borrower’s personal or business bank statements instead of a W2. The underwriters comb through the statements, looking for consistent patterns of deposits and debits for verifying the applicant’s monthly cash flow. It is a detailed and methodical process. Only verifiable income vs. projected income is allowable. The underwriting team will weed out any one-time deposits that are not considered regular income such as tax refunds.
During their manual application reviews, Non-QM underwriters not only evaluate borrower income, they also assess the borrower’s financial holdings such as marketable securities (stocks/bonds), retirement accounts and rental income. In Non-QM lending, these can be applied to loan affordability evaluations. Non-QM underwriters also have the flexibility to allow gift funds to be applied to the down payment or as cash reserves that may be required for loan approval.
Right now, there is a surge of interest in Non-QM underwriting due to a confluence of market trends. Even before the pandemic, the number of self-employed workers was growing by leaps and bounds. These are the prime candidates for Non-QM bank statement loans since they can’t produce employer issued W2s. Included in the self-employed cohort are entrepreneurs and business owners who, ironically, issue W2s to their employees but don’t receive them themselves. They can apply for a Non-QM mortgage using 12-24 months of business bank statements to document their income. As you may imagine, income verification for applicants using business bank statements is somewhat more involved; requiring a deeper dive into the company’s financials and cash flow.
In addition to manually evaluating each loan and being able to take the borrower’s entire financial picture into consideration, Non-QM underwriting teams are also free to be more collaborative and responsive. While traditional mortgage underwriters can take several weeks to make a determination, Non-QM providers —especially those with in-house underwriting teams — often have an answer within 72 hours. This is particularly important in a market where self-employed borrowers and business owners must compete with homebuyers securing traditional mortgages. Having a fast answer from underwriting on a bank statement loan application can make the difference between getting, or not getting, the deal done.
