Underwrite the borrower, or trust the down payment?

Question

I'm getting ready to put money to work on this side rather than owning buildings, and there's a fork in the road I can't reason my way past.

One school says the borrower is the loan. Pull credit, verify income, look at what they pay now versus what they'd pay you, ask why the bank said no. If the answer is a thin file or self employment income a lender couldn't document, that's one thing. If the answer is three collections and a repossession last year, that's another. The point of this work is that a performing note is worth far more than a defaulted one, and the cheapest default to avoid is the one you never write.

The other school says the collateral is the loan. Take 20 or 25 percent down, so the loan to value at creation gives you a cushion, and let the borrower's own money be their reason to pay. Under this view heavy borrower underwriting is a bank's job, you don't have a bank's tools, and if you get the house back with a quarter of the value below your basis you have not been hurt.

What makes me hesitate on the second one is that getting the house back has a cost and a calendar, and both vary by state.

I don't know which side is right and I'd rather hear the disagreement than a consensus.

hannah_west29 · Answer

Put numbers on the second school and it gets less comfortable. Say $200,000 price, $50,000 down, $150,000 note, so 75 percent loan to value. Borrower defaults in month eight. You're out maybe eight months of payments, foreclosure or termination cost, back taxes they stopped paying, insurance you had to force place, and whatever condition the house is in when you get it. Call it $25,000 to $35,000 all in on a modest house, plus resale costs of another 8 percent.

The $50,000 cushion absorbs that. It doesn't leave you happy. And that's the case where they put a quarter down. At 10 percent down the same sequence puts you underwater.

dpatel_re · Answer

Both, and the down payment is part of the underwriting rather than a substitute for it. I want to know the source of the down payment, because a gifted or borrowed down payment gives the borrower no skin in the deal no matter what the number says. I want to know current housing cost versus proposed payment, because a borrower going from $1,100 to $1,900 will fail regardless of credit score.

Credit reports get used for reason codes rather than the number. Medical collections and a thin file read differently from recent charged off installment debt. Pulling a consumer report requires a permissible purpose and the borrower's authorization, and how that plays out for a private seller is worth confirming with a lawyer before you order anything.

sonia_alvarez · Answer

The calendar is what settles it for me. In a judicial state a contested case can run past a year, and every month is taxes, insurance and no payments, so the cushion you underwrote at closing shrinks the whole time. Cheaper to say no at the front.

Underwrite the borrower, or trust the down payment?

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