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What is Credit Appraisal – Eligibility, Benefits & How It is Done?
17 November 2022
Ever wondered why loans get approved but also sometimes get rejected? Well, every bank has its own set of criteria that the borrowers must meet to qualify for a loan. This is where credit appraisal comes into play. Credit appraisal helps banks answer ‘to lend or not to lend’. But what are those parameters that determine eligibility? How is credit appraisal done? And, what are the benefits of credit appraisal? Read on to find out!
What is Credit Appraisal?
Credit appraisal is the process of conducting a preliminary assessment to determine the financial status before providing any loans, project finance or credit to individuals. The financial institutions and banks check if there is collateral or a security deposit available with the individual for the recovery of these funds in any given situation. In other words, it is essentially the process of checking the creditworthiness of an individual by going through their history of payments and studying their income. It helps banks to calculate the risk that is involved when loaning these funds. If a borrower does not meet the minimum requirements, then their loan application is generally rejected, or the credit amount is lowered.
How is Credit Appraisal Done?
The process of credit appraisal consists of a set of steps. Once all steps are completed, the credit is granted. The steps for credit appraisal of credit are as follows:
Step 1: Credit Processing
All applications and required information are gathered by the bank and processed. The application provided by the customer must ensure detailing of the reason for credit, and all information must be authenticated.
Step 2: Approval of Credit
Once the screening of individual applications is completed and vetted, the credit application is approved by the concerned authorities within the financial institution. The application is rejected if the process results in poor credit appraisal.
Step 3: Documentation
Post the approval of credit, all necessary documents are carefully documented in an orderly fashion. This ensures that the files are documented appropriately and are available at a moment’s notice.
Step 4: Administration
The final step of the credit process is to ensure that financial institutions are correctly administering their credit portfolios, including writing out proper loan agreements, renewal letters sent out in a timely fashion, and ensuring records are up to date. Most large organisations have a dedicated administration department that keeps the administration in check.
For an individual to be eligible for Appraisal, there are specific criteria which they must meet:
• Instalment to Income Ratio
This ratio is calculated to check how much of the borrower’s monthly income can be used to pay off loan instalments. Generally, this ratio lies somewhere between 33-40%
• Fixed Obligation to Income Ratio
This ratio is used to calculate the regularity of payments by the customer to pay off past and existing debts. Depending on this percentage, the loan amount provided to the customer is decided.
• Loan to Cost Ratio
This ratio is calculated to check the amount that the borrower can pay on the basis of the total amount of the loan requested. In other words, this ratio calculates the maximum amount that can be lent to the customer.
Benefits of Credit Appraisal
The benefits of performing pre-sanction Appraisal for financial institutions are as follows:
• Risk Analysis
Helps the banks to calculate the amount of risk involved in lending money to borrowers. The lower the risk, the more ready banks are to lend money to individuals.
• Confidence Among Banks
Since the creditworthiness of an individual has been determined, it provides a sense of security to bankers that the instalments will be paid by the borrower.
• Helps Determine Loan Amount
Depending on the creditworthiness of an individual, the amount that can be lent as a loan is decided, which can be repaid by the borrower and not put the banks at a financial loss.
Factors Evaluated During Credit Appraisal
Some of the factors that are evaluated by the financial institutions before approving personal or corporate credit appraisals are as follows:
The total income of the individual is studied to determine if the borrower has a fixed income and job stability.
• Repayment Capability
An important factor to consider in the repayment capability of an individual is their capacity to repay the amount borrowed from the bank. The higher the repayment capability of an individual, the better their chance to get the credit approved.
• Assets Owned
This is information that is analysed and kept with the bank to be used as collateral in case the borrower is unable to repay the amount borrowed.
This ensures that the borrower has not defaulted on any prior payments and has minimum liabilities they can afford to pay off.
Parameters in Credit Appraisal Process
There are specific parameters that credit providers look for in borrowers to determine their creditworthiness before providing credit. Some of the factors that are taken into consideration are as follows:
• Technical Feasibility
This is where the bank checks the living conditions and the standard of living of the borrower, which is an essential factor that will help decide whether the individual is creditworthy or not. The application is rejected if the borrower has a poor credit appraisal score.
• Economic Viability
This is where factors such as LTV and FIOR are taken into consideration, and the borrower’s credit history is checked to ensure that the individual will be able to return the funds that were provided as credit.
This step consists of steps like a credit interview to determine the borrower’s creditworthiness, and the individual’s profile is scanned, including information on valuable assets that can be used as collateral.
Credit appraisal is an important process that is crucial for financial institutions to follow in order to ensure that as they are handing out funds, the borrower is someone who is creditworthy and can afford to pay back the amount, thereby reducing the financial loss and bad debts that banks face. It is an efficient system that benefits both parties, the lender and the borrower, and helps ensure fair play in the banking and finance industry.
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Q1. Why do we need an appraisal of credit?
Ans: Credit appraisal in banks is an essential function to ensure that all borrowers can repay the loan amount to the bank and do not miss any instalment payment dates.
Q2. What are the 5 Cs of credit?
Ans: The 5 Cs of credit are: • Capacity • Character • Capital • Collateral • Conditions
Q3. What are the documents used for credit evaluation?
Ans: Documents used for credit evaluation are: • Income statement • Cash flow statement • Proof of Identity • Address Proof • Business Proof for corporate credit appraisal
Q4. What is the one mistake that can reduce your credit score?
Ans: One way to reduce your credit score is to make late payments. Keeping your payments in check and paying back loan amounts on time can help you maintain a good credit score and get loans faster.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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