What is loan rating?

The loan rating is a classification system that involves assigning a quality score to a loan based on the quality of the borrower. credit history, the quality of collateral, and the probability of repayment of principal and interest. A score can also be applied to a loan portfolio. Loan scoring is part of a lending institution’s loan or credit risk review system and is typically an aspect of the credit underwriting and approval processes.

A loan review system has many purposes, such as identifying loans with bad credit so that banks can take action to minimize credit risk, identifying trends affecting the collectability of the portfolio of loans and for financial and regulatory reporting purposes.

How loan ratings work

Being able to effectively manage your lending capacity is essential to a bank’s success. Thus, banks must offer a loan rating system that accurately assesses credit risk or the probability of loss due to a borrower’s default. The processes banks use to score loans help reviewers and management make good lending decisions. There is no correct loan rating system, although the Federal Deposit Insurance Corporation (FDIC) requires all lending institutions to have a loan review system. Large institutions may maintain separate departments specifically for reviewing loans.

Depending on the size and complexity, banks develop different approaches. Community banks often use broader factors to assess the risk of a loan, while larger and more complex institutions may rely on more quantitative approaches to measure and monitor credit risk. When assigning a rating to a loan, the reviewer reviews the loan documentation, guarantees and the borrower’s financial statements. The score takes into account not only the borrower’s credit score, but also a combination of several credit risk indicators from the credit report and the loan application. These factors may include the level of support from the guarantor, repayment history, cash flow, expected annual expenses, etc.

Small institutions generally use an expert judgment system. In this system, a loan officer is responsible for assigning a score based on judgment and knowledge. Other banks may use quantitative dashboards, or other modeled approaches, which allow adjustments based on qualitative judgments. Since no regulatory requirements dictate the structure of a loan rating system, it is up to banks to develop a system appropriate to their size and complexity.