Banking has come a long way from simple money landing functions to today’s multifunctional mega banks. Now, the banks have become big financial entities which cater to the various needs of a wide range of clients. These banks have complex working system, in order to remain viable and reliable. Let’s have a look at the working of these banks and these institutes decide whom to offer loan and how much.
Credit Appraisal:
This is the first and most important step in the process of granting a loan. With this step, a bank determines whether it would be feasible to extend credit to the borrower or not. Primarily, this step establishes the creditworthiness of the borrower. There are several stages in this process, which may include submission of various documents, inspection of those documents and meetings with the bank officials.
Different banks have different procedures for credit appraisal. Therefore the length of the total process as well as its complexity may differ from bank to bank. Further, a bank may have different procedures for different clients. Existing clients may have to go through lesser hurdles as the bank is already aware of their credit history.
Creditworthiness implies the borrower’s ability to repay the loan as per the schedule. A bank does not have unlimited resources and require the timely repayment of its loans, in order to sustain its operations. In order to obtain a loan, a borrower should carefully examine the selection criterions of the bank. It is very important for the bank to carefully select its borrowers as it may unnecessarily increase its risk profile.
In order to assess the creditworthiness of a borrower, the bank needs information about the client’s finances. It may need following information
- Income of the applicant.
- Income of the co-applicant.
- Educational qualification.
- Age
- Other liabilities.
- Assets of the applicant.
- Tax history.
Out of these, the most important determinant of the creditworthiness is the income level. Most of the banks set up a minimum threshold for income which must be met by the borrower. If the borrower already has existing loans, then the EMIs for them should be deducted from the income of the borrower to determine whether the loan should be granted or not. Further, the bank also needs to decide the quantum of the loan to be disbursed. In many cases, the bank sanctions the loan but not for the full amount applied for. This happens in the cases where the borrower is found creditworthy but not enough for the entire amount of the loan. Following are the main methods used by a bank to determine the amount of loan to be given.
a) The first method takes into account the income level and fixed obligations of the client. Fixed obligations denote the payments due on the existing loans taken by the client. However, obligations such as payment of life insurance or provident fund etc are not taken into account for this purpose. A person has net monthly income of Rs. 50000 and applies for a loan home loan with EMI of Rs. 20000 per month. The person already holds a vehicle loan for which he pays Rs. 5000 per month. In this case, the loan may be granted by the bank which uses 50% ratio as criterion, as after the grant of the loan, the person’s liability would be 50% of the net monthly income. However, a bank with 40% ratio criterion will either decline the loan or grant partial loan with EMI equalling 15000 Rs. per month.
b) Under this method, the loan is sanctioned up to a specified limit of the total expenditure proposed. For example, in the case of vehicle loans, the banks generally offer 90% of the total vehicle cost as loan. The remaining 10% needs to be borne by the borrower himself. Similar criterions are used in the case of other loans such as gold loan and land purchase loans. If a person is willing to buy a car worth Rs. 500,000, then with 90% criterion, the person may be granted only 450,000 Rs. as loan, provided other criterions are satisfied.
c) Third method works very much like first method. Under this method, the bank sets up the maximum limit for the ratio. For example, the bank may decide that the EMI should not exceed 20% of the total monthly income. In this case, a person with Rs. 20000 in monthly income may not be granted loans with more than Rs. 4000 in EMI. In this way, the bank is able to manage its risk profile and avoid granting the loans which may not be promptly repaid by the borrowers.
Some banks employ multiple methods and then grant the loan to the extent of the minimum amount generated by them.
