Chapter 12
Default Risk, Borrower
Qualification, and Loan
Underwriting, and Contractual
Relationships
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Chapter 12 Learning Objectives
 Understand the important borrower and property
characteristics that are the focus of borrower
qualification
 Understand the legal relationship between the lender
and the borrower and how contractual provisions give
each party rights and obligations
 Understand how the lender controls default risk
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Borrower Qualifications
 Mortgage Credit Analysis includes
1. Determining maximum loan amount
2. Estimating settlement requirements and costs
3. Analyzing credit history
4. Calculating effective income
5. Estimating monthly housing expense
6. Assessing ability to repay mortgages and other liabilities in
a timely fashion
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Credit Scoring
 Used to assess creditworthiness of the borrower
 The best known company providing credit scores is
Fair, Isaac and Company (FICO)
 Uses credit, income, outstanding debt and debt utilization
over the years, access to credit
 Numerical score from 300 – 900
 Cutoff score for Fannie and Freddie for a prime mortgage –
620
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Theories of Default
 Ability-to-Pay Theory
 Default when the borrower cannot make monthly payments on
the loan
 Foreclosure after several payments are missed
 Equity Theory (The Put Option)
 Focuses on the amount of equity in the property
 Assumption: no borrower with substantial positive equity will
default, even if unable to make monthly payment
 Borrower with substantial equity can sell the property in the
market and payoff the loan, capturing the equity
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Studies of Delinquency and Default
 Home equity and LTV – the main characteristics
influencing the default decision
 Other factors – Transaction costs and difficulty of estimating
the default option value
 Shorter maturity loans and loans on new houses much
less likely to default
 Default peaks within 3 – 5 years from origination
 Default also related to family size, source of income,
and unemployment
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Characteristics of the Property
 Lenders require that an appraisal of the property be
performed as a part of the qualification procedure
 Appraisal done by an independent, third-party appraiser
 Standardized appraisal process and form for FHA, VA and
conventional loans by state licensed or certified appraiser
 Appraised value determined by:
 A function of physical characteristics (square footage, number of
bedrooms, structure, age), location, financing, etc.
 Based on three or more comparable properties’ recent selling
prices
 The value of the residence as a rental property
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Characteristics of the Borrower
 Type and stability of income
 Supplemental sources of income
 Other debt and living expenses
 Borrower qualification for conforming conventional,
FHA and VA loans compare maximum ratios of
housing related expenses to gross or after-tax income
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Borrower Qualification
 Credit scoring – statistical method to assess credit risk
 Subprime loan – made to borrowers without top grade
credit
 Higher rates for subprime loans, not quoted publicly
 Easily accessible market rates on conforming loans
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Borrower Qualification
 Risk-based lending – matches the borrower to a series of
risk profiles and rates the likelihood that a loan will be
repaid
 Use of FICO scores
 Weights in calculating credit score: 35% payment history, 30%
level of debt; 15% types of credit; 15% length of credit history; 5%
number of inquiries
 A-F ratings based on profiling
 A borrower – low default rate and can obtain higher LTV ratio
 D borrower – poor credit and high LTV
 F borrower – currently in bankruptcy or foreclosure
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HUD/FHA Guidelines
 Use of payment-to-income ratios
 “Front end” ratio – The ratio of monthly total mortgage
payment (TMP) to gross monthly income
 “Back end” ratio – The sum of TMP and other monthly
expenses to monthly effective (regular plus supplemental)
income
 Payment-to-income ratios exceeding 31-43% generally lead
to denial of loan application
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HUD/FHA Guidelines
 Definition of housing expenses
 Include principal, interest, taxes and insurance (PITI)
 FHA adds to PITI – monthly mortgage insurance premium (MIP)
and any homeowner association or condominium fees
 Definition of Income
 Gross monthly income – the gross income from all sources that
can be expected to continue for the first 5 years for the mortgage
 Difficulty of estimating effective income for self-employed
borrowers (with >= 25% ownership in a business)
Lender must verify at least 2 years of income
Borrower must have been self-employed for at least 2 years
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VA Borrower Qualification
 VA mortgage loan program designed to help veterans
finance the purchase of homes with favorable loan terms
 VA employs a two-step method
 Residual method – minimum residual income based on PITI, less
utilities and maintenance costs, less additional monthly
payments, less monthly living expenses costs (food, clothing, and
transportation)
excess residual income = minimum residual income minus net effective
income
 Income ratio method – used in conjunction with the residual
method
Housing (PITI) plus other (loan repayments, installment obligations and
child support) expenses <=41% of gross income
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Borrower Qualifying Ratios
 Loan-to-Value Ratio (LTV)
 The higher the LTV Ratio, the higher the default risk
 Historic Payment-to-Income Ratios
Conventional
FHA/VA
PITI
28%
29%
PITI+other
36%
41%
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Mortgage Contracts
 Mortgage – Defines the debt and creates the lien against
the property
 Promissory Note – Outlines the provisions of the loan
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Recourse vs. Non-Recourse
Interest and Payment Structure
Pre-Payment
Default and Acceleration
Due-on-Sale Clause
Amount of Loan
Assignment of Rents and Income
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Deed-of-Trust
 An instrument that serves as security for a note
 Parties to the deed: borrower (trustor), lender
(beneficiary) and trustee
 The trusty (a third party) holds the deed of trust
 In case of default the trustee is in position to quickly
liquidate the property
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Provisions of a trust deed
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Assignment of rents
Waste
Nonwaiver
Security protection
Successors and Assigns
Substitution of Trustee
Reconveyance
Release Clause
Owner-Occupancy
Award from Eminent Domain
Covenants and Restrictions
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