Lenders writing mortgages must consider the danger posed by borrowers who prove to be unwilling or unable to make the agreed mortgage payments. Financial professionals refer to potential borrower default as mortgage risk. Lending underwriters must assess the likelihood of both missed payments and complete abandonment of the loan.
Financial institutions use many tools to calculate the level of mortgage risk involved in each loan. The first tool used by lenders is a credit check. Most lenders check the credit scores of mortgage applicants by pulling their credit history reports. Credit reports enable lenders to evaluate the ability of a loan applicant to make timely loan payments. People who have a poor credit score pose a greater degree of mortgage risk and are often ineligible for loans.
Loan originators gather documents including income statements, tax returns and recent pay stubs to verify the monthly income of loan applicants. Anyone with a high debt-to-income (DTI) ratio exposes the lender to a greater level of mortgage risk because a lack of surplus cash leaves the borrower ill-equipped to deal with unexpected expenses. To minimize mortgage risk, many mortgage issuers do not lend to individuals with DTI ratios above a certain percentage, such as 45 percent.
Home appraisals play an important role in establishing the risk level of a particular loan. A mortgage amount cannot exceed the value of the home used as collateral. To reduce the risk to the lender posed by depreciating home prices, most mortgagees limit loan-to-value (LTV) ratios, with 80 percent being a common limit. People with high credit scores, low DTI ratios and homes in desirable locations, might be able to establish mortgages with higher LTV ratios.
After establishing the level of mortgage risk posed by a particular loan, lenders must price the loan. To mitigate the risk of default, lenders charge higher closing costs and interest rates on loans that are taken out by high-risk borrowers. People who have excellent credit are rewarded with low rates and less-stringent underwriting guidelines.
Financial institutions share the inherent mortgage risks with other entities such as mortgage insurers and investors. Mortgage insurers charge monthly premiums for insuring the lender in the event of borrower default. Investment companies buy mortgages and divide them up into bonds that are sold to investors. People buying mortgage-backed bonds receive interest payments that are derived from the mortgagor's monthly payments. Investors are exposed to mortgage risk because if the borrower defaults, the mortgage bonds become worthless.