Credit risk
The chance that a borrower will default and fail to repay, causing the lender a loss. It is inherent in every loan and is what underwriting is designed to measure and price.
Key Takeaways
- Credit risk is priced rather than eliminated. A weaker file usually draws a higher rate, a larger down payment, or mortgage insurance instead of a flat refusal.
- Lenders measure credit risk through repayment history, credit score, debt-to-income ratio, cash reserves, and the loan-to-value ratio on the property.
- When Freddie Mac or Fannie Mae guarantees payment on a security it sells, it takes on the credit risk of those loans in exchange for a fee.
- In Washington a lender that forecloses a deed of trust by trustee's sale generally cannot pursue the borrower for the unpaid balance.
What It Means
Credit risk is the chance that a borrower stops paying and the lender loses money on the loan. Every loan carries some. Underwriting does not exist to find borrowers with none, since there are none. It exists to measure how much risk a file carries and to charge for it.
Underwriters look at repayment behavior first. A borrower who pays on time and keeps balances under control looks like a good credit risk, and that behavior is what the Credit Score summarizes. They then test capacity with the Debt To Income Ratio, count the reserves left after closing, and check how much cushion the property itself provides through the Loan To Value Ratio. A larger down payment lowers credit risk twice over, because the borrower has more of their own money at stake and the lender has more equity to recover from.
Risk that cannot be priced away gets moved somewhere else. Mortgage insurance shifts part of it to an insurer, and a guarantee from Freddie Mac or Fannie Mae shifts it to the guarantor for a fee.
How It Works in Washington
Washington changes the shape of credit risk at the back end. Home loans here are typically secured by a Deed Of Trust, which chapter 61.24 RCW governs and which lets the lender foreclose nonjudicially through a trustee's sale instead of suing in court.
That speed comes with a trade. RCW 61.24.100(1) provides that, except to the extent permitted for deeds of trust securing commercial loans, a deficiency judgment shall not be obtained on the obligations secured by a deed of trust against any borrower, grantor, or guarantor after a trustee's sale under that deed of trust. In plain terms, once a Washington lender takes an owner-occupied home through a trustee's sale, the house is the recovery. The lender cannot chase the borrower for what is still owed. A lender that wants to preserve a deficiency claim has to foreclose the deed of trust judicially as a mortgage instead, which RCW 61.24.020 allows and which is slower and more expensive.
That is why loan-to-value carries so much weight in Washington pricing. The collateral, not the borrower's future paycheck, is what backstops the loss. Our guide to interest rates and Washington home sales shows how a weaker file changes what a buyer can offer.
Example
Ravi and Dana borrow $520,000 on a $650,000 house in Everett, an 80 percent loan-to-value. Their middle credit score is 762, their debt-to-income ratio is 34 percent, and they hold four months of reserves after closing. The lender prices the loan at its base rate with no mortgage insurance.
Their friend Colby buys a $650,000 house on the same street the same month. His middle score is 648, his debt-to-income ratio is 44 percent, and he puts 5 percent down, so he borrows $617,500 at a 95 percent loan-to-value. The lender does not decline him. It approves the loan at a rate three quarters of a percent higher and requires mortgage insurance on top. Same street, same month, same house price. The difference in what Colby pays is the lender charging him for the extra credit risk his file carries.
Common Mistakes and Exam Traps
- Credit risk and interest rate risk are different exposures. Credit risk is the borrower failing to pay. Interest rate risk is the lender's return losing value when market rates move.
- A high credit score alone does not make a low credit risk file. Capacity, measured by debt-to-income, and collateral, measured by loan-to-value, are weighed alongside it.
- Mortgage insurance protects the lender, not the borrower, even though the borrower pays the premium.
- When Freddie Mac guarantees a security it sells, it assumes the credit risk on those loans. The investor still carries prepayment risk and interest rate risk.
Where you'll learn this
Frequently Asked Questions
How is credit risk different from the risk that a property loses value?
Credit risk is the borrower failing to repay. Property value is what limits the lender's loss when that happens. A lender manages both, which is why it underwrites the borrower and orders an appraisal on the collateral.
If a Washington borrower loses the home at a trustee's sale, can the lender collect the shortfall?
Generally no. RCW 61.24.100 bars a deficiency judgment against a borrower, grantor, or guarantor after a trustee's sale, apart from the commercial loan exceptions the statute spells out.
Why would a lender raise the rate instead of just declining the loan?
Because credit risk is priced, not judged pass or fail. A higher rate, a bigger down payment, or mortgage insurance compensates the lender for a greater chance of loss, and that lets more borrowers qualify than a yes or no test would.