Loans usually involve a more complicated process than it seems. Most times, lenders consider many factors and even assign scores to loans to determine how viable they are. That’s where Loan Grading comes in.

What is Loan Grading?

Loan Grading is a classification structure that scores a loan based on the loan’s quality. It is also called loan scoring. Institutions apply loan grading to prospective loans and existing loans. 

Institutions score loans by assigning letters that depict the risk of loss of a loan. Loans with lower grades will have lower interest rates, while higher loan grades have higher interest rates.  The higher interest rates will help compensate for the risks of the lender.

Loan grading also assesses loan portfolios. A loan grading serves as a component of a lender’s loan evaluation and credit risk management system. The loan grade is also essential in the assessment and approval procedure of a loan.

Factors that Affect Loan Scores

Three factors usually determine loan grades or scores. They are

Borrower’s Credit History

Credit history shows a borrower’s record of paying back debts. It also contains the amount of borrower’s credit accounts and whether a borrower pays bills on time. Credit history also states whether a borrower has bankruptcies or liens.

Quality of the Guaranty or Collateral

This factor considers the value of the asset the borrower puts down as security for the loan.

Borrower’s Likelihood of Repaying

This assesses the likelihood of the borrower to repay the principal and interest when the loan is due.

How a Loan Grading Works

Banks and other lending institutions know that their credit management can determine success. Thus, they need to formulate loan grading schemes that correctly analyse credit risk and the possibility of a loan loss.

There are no rigid approaches to loan grading. The loan grading system adopted by institutions depends on loan complexity and size. Nevertheless, a loan evaluation system is a requirement for institutions that offer lending services.

Small or community-based banks use wide-ranging factors to determine loan risk. They usually employ expert judgment procedures in their loan review process. This process involves a loan officer assigning a score to a loan based on his/her knowledge. The officer usually considers factors like the collateral, loan documentation, and a borrower’s financial statements.

On the other hand, Larger institutions employ quantitative approaches that may allow them to make adjustments based on qualitative considerations. Some large institutions may have specific subdivisions that review loans.

Why Do Institutions Use Loan Grading?

Minimise Risk

Loan Grading helps lending institutions to minimise risks. Loan grades point out loans that may have disadvantages. That way, banks will be able to act on reducing or eliminating their risks.

Identify Issues Affecting Loan Collectability

Loan Grading allows institutions to identify issues that affect loan collectability. Through this, banks can readily analyse trends that may prevent the borrower from repaying and prevent these trends.

Reporting Functions

Loan Grading serves reporting functions. Through loan grading, institutions can document their financial and regulatory process. This documentation will form the basis of their report on the loan review system they adopt.