Loan Documentation: The Last Line of Defense
For both a lender and a borrower, the loan application, underwriting and approval process can be stressful for any number of reasons. There is a sense of relief and accomplishment when the loan is approved. However, the potential for credit risk to increase because of poor loan documentation remains a risk that some lenders do not consider.
“It’s just a mortgage”
A client reached out to us last week about two loans we had underwritten earlier this year. One loan closed in January. The other loan had not yet closed.
In February, the Borrower was late making the first payment on the smaller of the two loans. While this turned out to be a processing error, the Lender followed their internal process and pulled a credit report on the business owner. Our client observed a new residential mortgage on the credit report. Our client was completely unaware the owner was buying a home. The owner had not disclosed that they were purchasing a home during the application process.
When the lender asked about this new loan, the response of the borrower brought to mind character concerns that when coupled with the financial impact gave the lender significant reason for concern. The owner stated: “It’s just a mortgage and I can buy a house if I want.”. Our client was in a position to revoke the commitment on the larger loan. The borrower violated a “no material omissions” clause included in the commitment letter. Thankfully, our client’s loan documentation included appropriate checks and balances.
Best Practices for Your Loan Documentation
The specifics of this situation aside, we were once again reminded about the importance of good loan documents starting from the application to the term sheet all the way to the legal documents used to close a loan.
The best practice for lenders no matter how sophisticated include:
- Outside legal counsel should reviewed all loan documentation. This includes the application the borrower prepares with each loan.
- Employees that can issue term sheets and commitment letters must be outlined in policy.
- Review all closing documents against the approval document and commitment letter. Address any discrepancies before the loan closing.
- Permit no changes to documentation at the closing table.
- Term sheets and commitment letters should have reasonable expiration dates. Once the document expires, the Lender should re-start the application process.
It is almost impossible to correct loan documentation errors after the loan closing. One bad set of loan documents can increase the credit risk profile of a loan portfolio. Taking time to integrate these best practices can go a long way to prevent increasing credit risk in a loan portfolio.
