As a community banker, you’re no stranger to the ebb and flow of economic trends. You understand that your bank plays a critical role in providing financial services that strengthen the local economy, and perhaps nowhere is this more important than in the mortgage market. But as the financial landscape continues to shift, underwriting mortgages that stand the test of time can feel like trying to predict the weather—challenging and, at times, uncertain.
The good news? While market dynamics may change, there are reliable strategies your loan team can implement to underwrite mortgages that balance risk and reward, ensuring both the borrower’s and the bank’s long-term financial health. Here’s how your team can reduce the risk of borrower default, even when the market is unpredictable.
1. Know Your Borrower Beyond the Credit Score
It’s easy to get laser-focused on a borrower’s credit score—it’s one of the most common measures of financial reliability. But credit scores don’t tell the full story, especially in today’s economy where many potential borrowers might have strong earnings but a few blemishes on their report.
Take the time to evaluate the borrower’s full financial picture. How stable is their income? Do they have consistent employment or operate a well-established business? What does their debt-to-income (DTI) ratio look like? Is there a history of managing expenses responsibly? While credit score matters, digging deeper into the borrower’s full financial landscape can provide valuable insights and reduce the risk of default.
Consider using a holistic approach to underwriting, factoring in details like savings history, other assets, and even the stability of the industry the borrower works in. It’s not just about numbers on a page but understanding the person behind the loan application.
2. Stress Test the Mortgage
Stress testing isn’t just a tool for large financial institutions—community banks can benefit from it too. Essentially, a stress test examines how a mortgage will perform under unfavorable economic conditions. What happens if interest rates increase, property values drop, or the borrower’s income decreases?
One effective way to stress test a mortgage is to assume a rise in interest rates and check if the borrower can still afford the payment. Even with fixed-rate mortgages, borrowers may face financial strain from other economic factors such as job loss or a recession.
By performing this analysis, your team can create a buffer and identify risk factors early on. If a borrower’s financials look tight during the stress test, you can either suggest a smaller loan amount or ensure they have additional financial reserves to cover any potential downturns.
3. Set Reasonable Loan-to-Value (LTV) Ratios
The loan-to-value ratio is a crucial metric in mortgage underwriting. It measures the loan amount against the appraised value of the property. The higher the LTV ratio, the more risk your bank takes on, as the borrower has less equity in the home.
In a dynamic market, it’s essential to remain conservative with your LTV ratios. While a higher LTV ratio may be tempting to approve, especially in a competitive lending environment, it leaves little room for property depreciation or financial setbacks.
A solid benchmark to aim for is an 80% LTV ratio or lower, ensuring that the borrower has a meaningful equity stake in the property. This not only reduces the risk of default but also lowers the chances of the borrower walking away if the property value declines.
4. Understand the Local Real Estate Market
As a community bank, one of your advantages is having a deep understanding of the local housing market. Use this knowledge to your advantage when underwriting mortgages. Housing prices can fluctuate dramatically depending on the region and economic conditions, so it’s essential to stay on top of local real estate trends.
Are prices rising too quickly? Is there an oversupply of new developments that might cause property values to stagnate? Are there industries in your area that are expanding or contracting? By staying in tune with these factors, your loan team can better assess the risks associated with particular mortgages.
Additionally, having good relationships with local appraisers and real estate agents can provide insight into whether properties are accurately priced, helping you avoid over-lending on homes that may not hold their value over time.
5. Build in Flexibility for Borrowers
A fixed-rate mortgage might offer stability, but it’s not always the best option in a fluctuating market. Offering borrowers more flexible products like adjustable-rate mortgages (ARMs), or hybrid options that combine a fixed rate for a few years followed by adjustments, can make a difference in reducing default risk.
However, this flexibility should be paired with education. Many borrowers may be unfamiliar with how ARMs work or might only see the lower initial rates without understanding the potential for payment increases. Transparency and education are key here—make sure borrowers know exactly what they’re getting into.
Also, consider offering temporary rate buydowns where borrowers can start with lower payments that gradually increase. This strategy works particularly well for borrowers who expect their income to grow in the near future, providing them with breathing room as they settle into their mortgage.
6. Encourage Financial Preparedness
One of the most proactive steps your loan team can take is to educate borrowers on financial preparedness. It’s in everyone’s best interest that borrowers have a financial cushion to cover unexpected events—whether that’s a job loss, medical emergency, or a sudden increase in expenses.
Encouraging borrowers to maintain an emergency fund and providing resources on budgeting and saving can go a long way. In fact, some community banks offer financial wellness programs that equip borrowers with the tools and knowledge to manage their finances better, making them more resilient during tough economic times.
Community Banks Can Lead the Way
Underwriting mortgages in a dynamic market isn’t about guessing where the economy is headed—it’s about preparing for all possibilities. By knowing your borrower beyond the basics, setting reasonable LTV ratios, stress testing mortgages, and leveraging your local market expertise, your community bank can ensure its mortgage portfolio remains healthy and borrowers stay in their homes, even in unpredictable times.
At the end of the day, the goal is to build long-lasting relationships with your customers, offering them the support and flexibility they need while protecting your bank from unnecessary risks. When your borrowers succeed, so does your bank.