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What Is A Risk Rating?

What Is A Risk Rating?

More and more loans are being granted every day. Before approving the next loan, ask yourself: is the risk worth the ROI? Where is the line between reaching portfolio goals and knowing when to walk away?
Studies have been conducted to educate and encourage financial institutions to implement loan pricing models. These models are designed to incorporate the analytics required to determine if the pricing on a given commercial loan meets the profit objectives of the financial institution.

Because risk rating is an integral part of loan pricing, a review of the variables that drive that ratio is extremely important. A lower risk rating will yield lower loan pricing while a higher risk rating will yield higher loan pricing.

When reviewing the borrowers eligibility, you will look at these 4 areas:

  1. Financial – number of revolving accounts, debt to available credit, debt to income ratio, and spending trends.
  2. Security – liquid accounts and personal equity.
  3. Management – payment history, length of time accounts are open, and number of closed accounts
  4. Environmental – type of current employment, length at current employment, amount of income, family and living situation.

Risk based pricing needs to be both objective and subjective. Each area is awarded a score based on its strength or weakness. Once the evaluation is complete and the score tallied, the risk rating is determined.

Conducting risk ratings has many benefits including:

  • It lets you know what kind of price/fees will satisfy your risk/return preferences
  • Properly measured and priced loans increase shareholders value
  • Improves loan and relationship profitability
  • Provides growth in credit portfolio goals and objectives
  • Ensures that the inherent risks found within are sufficiently accounted for and satisfy the regulatory requirements.

A loan pricing model will become an invaluable tool to view the implications of seemingly minor changes in a loan pricing structure to the profitability of a loan being priced. This can prove to be invaluable to the bottom line profitability of the institution. Contact us today to learn more about risk ratings and how we can fill your loan pricing model needs.