Loan grading is the process of assigning a quality score to a loan application to identify a risk of default. This score is based on the borrower’s credit history, quality of the collateral, and likelihood of repayment. Loan grading can be done for an individual loan as well as for a portfolio of loans.
Loan grading is usually part of the underwriting process and is part of the lender’s credit risk management system. It helps the lender minimize risk and identify factors impacting the likelihood of repayment.
Learn in more detail how lenders use loan grading and how you can improve your loan grade.
Definition and Example of Loan Grading
Loan grading is the system a bank uses to evaluate the likelihood that borrowers will fail to make their loan payments. Having a loan grading system in place ensures that banks can make good lending decisions. It establishes a cutoff point to help lenders decide how much risk they’re willing to take on.
Some financial institutions have entire departments dedicated to loan grading and assessing a potential borrower’s credit risk. Smaller banks may rely on the individual judgment of loan officers, while larger financial institutions may streamline this process using technology.
- Alternate name: Loan scoring
For example, say you have an excellent credit history and stable income. If you take out a mortgage with your community bank, the bank may classify the loan as “pass.” However, if you had a questionable credit history, say a history of making late payments, your bank may grade your mortgage as “substandard” or “doubtful.” Banks have different systems for grading loans and different labels for their grades.
How Does Loan Grading Work?
Every loan comes with a certain level of risk, so lenders need to find a way to minimize this risk as much as possible. In fact, the FDIC requires federal banking agencies to have safety standards in place.
Loan grading standards must address the following areas: asset quality, internal controls, credit underwriting, and loan documentation.
All loan review systems are designed to meet the following objectives:
- Identify credit weaknesses so the bank can take appropriate action.
- Identify trends that affect a loan portfolio.
- Isolate potential problems in a loan portfolio.
- Track the institution’s compliance with laws and regulations.
- Obtain information that can be used for reporting purposes.
The loan grading process that a bank uses helps it make good lending decisions and lower its credit risk. Loan grading systems vary on how complex they are depending on factors like the size of the financial institution and its management practices.
Some banks have loan officers responsible for reviewing borrowers’ loan applications, financial documents, and collateral. From there, the loan officer uses their best judgment to determine whether or not to approve the loan. Financial institutions might also automate the underwriting process by using technology.
How Does Loan Grading Affect Credit Risk Management?
Financial institutions can face significant problems related to lax credit standards or poor portfolio risk management that don’t properly account for the likelihood a borrower will fail to repay a debt obligation.
Credit risk management, including in loan grading, is essential to ensure a bank’s safety and soundness. It helps lenders minimize losses by lowering risk within acceptable standards, which helps to avoid losses and maximize profitability. Credit risk management also helps financial institutions understand whether their capital and loan loss reserves are enough to cover potential losses at any given time.
For many financial institutions, loans are their biggest credit risk. Lenders typically look at the six “C’s” to determine a borrower’s creditworthiness:
- Collateral: Putting down some type of collateral offsets some of the risks to the lender and could improve your odds of approval.
- Capital: Additional capital and assets could improve your ability to qualify for a loan.
- Capacity: When you apply for a loan, the lender considers your financial capacity to repay it. Your monthly income and expenses help the lender gauge whether you can meet your monthly loan payments.
- Conditions: A lender will also consider current economic conditions that could affect your ability to meet your loan payments as well as industry trends or proposed legislation.
- Character: Your job history, experience, and credit history all help your lender get a sense of your character.
- Communication: Your lender will consider your willingness to communicate openly with the bank about your loan.
- Loan grading assigns a quality score to a loan based on the borrower’s credit history, quality of the collateral, and repayment risk. It can be done for an individual loan or a portfolio of loans.
- This type of grading is part of both the lender’s credit risk management system and an important part of the underwriting process.
- With loan grading, lenders look at various credit risk indicators, including the borrower’s credit score, repayment history, and monthly expenses.
- The FDIC requires that all financial institutions have a loan review system in place.