In the modern mortgage market, particularly post-2008, one of the most crucial aspects of designing and executing a successful product is risk assessment. Gone are the days of borrowers’ cozy relationship with loan officers or bank executives acting as the primary driver for loan approval or interest rates. When proper risk management is necessary not just to close a loan, but to ensure it performs—either in portfolio or as part of a security held by an investor—a rigorous evaluation of a potential borrower’s creditworthiness is in order.
This was, in part, the thinking behind the 2010 Dodd-Frank Act, which created the Consumer Financial Protection Bureau (CFPB), and instituted a host of new mortgage-focused regulations and requirements, designed to, in the words of then-Treasury Secretary Tim Geithner, “prevent(s) financial firms from taking risks that will threaten the economy.” He also argued, in support of the bill, that it would “provide(s) the government with significant new tools to better protect taxpayers from the damage of future financial crises.”
VOA (and verification of income) is not only a requirement under Dodd-Frank, for all Qualified Mortgages, but it is a crucial part of mitigating risk and protecting lender and investor portfolios.
Let’s start with some definitions. There are two broad classes of assets: liquid and non-liquid. When calculating the value of a potential borrower’s assets, both should be included, and the more diversified the borrower is, the better their credit profile is likely to be. Tip: make sure to encourage your borrowers (both existing and potential customers) to safely and carefully diversify their portfolio by pursuing investments in both classes.
Example of liquid assets include (but are not limited to the following):
There are significant advantages to having a sizable portion of your assets in liquid form, of course. The average mortgage lender typically suggests borrowers have at least six months’ worth of liquid assets to plan for an unforeseen financial issue. This ensures that you have a way to continue your mortgage payments, should something happen to your main source of income. This strategy is particularly relevant in our current economic environment, which is marked by uncertainty, unemployment/labor shortages, inflation, etc.
One potential pitfall: lenders cannot work with untraceable funds claimed by a borrower. That likely means that cash deposits into a bank account may not be able to be used. Such deposits can even poison the entire account, so that none of the funds can be used for a purchase transaction.
Non-liquid assets are those items that cannot be easily converted into cash, including (but not limited to):
Other examples might include animals (horses, herds of livestock, etc.) or large physical equipment, like tractors.
Two recently-created investment classes that deserve mention here are cryptocurrency and non-fungible tokens. Currently, the question of liquid vs non liquid for cryptocurrencies like Bitcoin, depend on several factors. Check out this helpful article from digital lending experts at SodFi for a closer look at the topic.
Non-fungible tokens, or NFTs, face similar challenges when it comes to liquidity. While these one-of-a-kind digital assets (think artwork, music, sports highlights, GIFs, etc.) do indeed hold value, that value is volatile, and highly dependent on the state of the digital currency it is typically traded in.
Both types, or classes, of assets have unique characteristics, and properly valuing each is critical to determining the true creditworthiness of a potential borrower.
How lenders verify assets can vary widely. A more labor-intensive, manual process will require a borrower to submit detailed paperwork verifying all assets. That would include everything from bank statements to tax returns for the simple items, but for the more complicated, non-liquid assets, borrowers might need to find more creative ways to prove value. An appraiser’s report for land, jewelry, or artwork will likely suffice, but for the digital assets mentioned above, each lender is likely to have their own way to value the items.
Lenders must verify that all of the assets listed on a loan application are verified, properly sourced, and seasoned (if necessary). They do this by, for example, reviewing the two most recent statements for any accounts listed on the application. (in some case, 6 months of statements may be required). When reviewing said statements, each and every deposit must be individually verified.
To begin with, an underwriter will take note of any recent large deposits. They may examine every deposit on a potential borrower’s account, attempting to match it to the reported income. Keeping good records of the origination of deposits will help speed the process. For example, having recently sold a vehicle for a profit would raise flags if a Bill of Sale, copy of check and any other relevant documents are not available.
Other items that might catch the eye of an underwriter—a recent non-sufficient funds charge, without a reasonable explanation or documentation.
Lenders also look for signs of responsible financial practices, including reserves. This is funds the borrower has on hand should their income fall or cease altogether. Having reserves gives the lender (and investors) confidence that the mortgage payment could be made even in the event of a short gap in employment. Lenders will calculate how many mortgage payments you could make with those assets alone.
For example, let’s say the borrower has $7,500 in liquid assets available. If the mortgage payment is $1,500 (with taxes and insurance included), the borrower would have 5 months of reserves available. The lender could use this as an offsetting factor in the case of a less-than-great credit score or high DTI ratio. In fact, some loan programs actually require borrowers to have reserves on hand—all the more reason for borrowers to act with financial wisdom.
An alternative to the manual process is an API-powered, auto verification system that connects seamless to both your existing tech stack and the various banks and financial institutions that will be called upon to verify the accounts. This process offers many benefits to both lender and borrower, including speed, transparency, and accuracy.
Instead of waiting on human underwriters to make phone calls or send emails and wait for return messages and documents, processors can connect instantly with the proper institutions and get a quick response. Additionally, by not having to wait for a human on the other end to respond to a request, the lender (and therefore the borrower) aren’t left wondering about the status of the inquiry.
Finally, human error is not an insignificant risk, and having the ability to minimize that through connected systems and simplified request processes can save time, and money, and ultimately increase pull-through rates and loan volume.