BANKING SERVICES Ch. 7.3 Granting & Analyzing Credit

Banks Must be Careful When Granting Credit Bad loans are the #1 reason banks get into financial trouble. Banks need to make sound decisions about loans, and they need a defined method of granting loans.

Net Charge-Off The total of loans & leases removed from a balance sheet because they are uncollectible minus any funds from prior charge-offs that were collected.

Banks Must Minimize Risk Banks take a number of steps to minimize making bad loan decisions. These steps are part of well-defined policies of risk management.

Risk Management Banks face risks in:  1. operations  2. credit  3. liquidity  4. legal  5. regulatory compliance  6. marketing These factors all influence the credit-granting process

Risk Management Policies under Scrutiny A bank’s risk management policies are carefully scrutinized by bank examiners during an audit. Sometimes legal requirements complicate things. Banks must document that they comply with the law in extending credit fairly & equally

Credit-Approval Process 1. Application 2. Documentation 3. Processing 4. Underwriting 5. Closing 6. Funding

Step 1: Application All information must be correct Bank representative helps consumer with this step as part of a loan analysis or a needs analysis. Helps consumers decide what type of loan they need.

Step 2: Documentation Credit report Employment verification Bank account information Appraisal of properties (for secured loans)

Step 3: Processing The bank builds a loan file The loan officer verifies statements on the application & checks info on all documentation Loan officer may ask for explanations or seek further info during this step

Step 4: Underwriting When all required info has been gathered and verified, the loan officer forwards the loan file for underwriting. Underwriting – reviewing the loan for soundness The underwriter’s job is to make sure the loan is a prudent use of bank funds.

Underwriters Evaluate the 3 Cs 3 Cs that Underwriters Evaluate:  1. Collateral  2. Capacity (the ability to repay based on income, job history, & amount currently owed)  3. Credit reputation (how well they’ve repaid in the past) Based on these factors, the underwriter approves or disapproves the loan.

Automated Underwriting Today, underwriting is increasingly automated. Software programs provide statistical analyses & models based on vast quantities of data. Banks may sometimes offer a loan at “subprime rates” Subprime rates- rates that are higher than normal to offset the increased risk represented by a less- than-perfect borrower

Step 5: Closing At the closing, a bank representative discusses & explains the terms of the loan, & the borrower signs the documentation that has been prepared.

Step 6: Funding When the documents are signed, the bank either adds the funds to the borrower’s account or issues a check.

CRAs Consumer reporting agency – a company that compiles & keeps records on consumer payment habits & sells these reports to banks to use for evaluating creditworthiness Sometimes called “credit bureaus”

CRAs CRAs report whether a person has been sued, arrested, or has had financial judgments issued against them by a court 3 Main Credit Bureaus:  Equifax  Experian  TransUnion

Credit Reports Contain: Personal data – name, ss#, addresses, employment Accounts history – detailed history of active credit accounts Delinquent accounts – past due accounts or late payments (often utilities, doctors, landlords) Public records – bankruptcies, judgments, liens, divorces, child-support, criminal records Inquiries – everyone that has requested a copy of the credit report within the last year

Check Your Credit Report At least once a year (free) Check for errors, identity theft, etc. The Fair Credit Reporting Act guarantees consumers the right to review & dispute information in the reports. Be persistent if you find errors.

Credit-Scoring System Scores that place a numerical value on the person’s creditworthiness Various categories are rated and weighted:  Income  Debt  Age  Years on the job

FICO FICO Score – a 3-digit number that credit granters can use in making a loan approval decision It weighs all categories of information Excludes income & the type of credit for which the applicant has applied Also excluded are: race, ethnic background, religion, gender, & marital status

Criteria Used for FICO Score: Payment History (35% of score) track record on accounts such as credit cards, installment loans, mortgages Also includes info about public records of collection, bankruptcies, judgments & wage attachments Details on late payments & how many accounts have no late payments appear

Amounts Owed (30% of FICO score) Total amounts owed on all accounts, the types of accounts that are open, how many of those accounts have balances, how much of a credit line is in use, how much is still owed on installment loans compared to the original loan value.

Length of Credit History (15% of score) Considers how long accounts have been established & how long it has been since each was in use A long, solid credit history increase the FICO score

New Credit (10% of score) Often sought by people in financial trouble Too much new credit is a sign of overextension FICO considers how many new accounts exist, how long they’ve been open, how many recent requests for credit have been made

Types of Credit (10% of score) Shows what types of accounts exist & how many there are of each A “healthy mix” of credit yields a higher score than a dependence on a single type of credit account.

FICO Scores Range between 300 to 900, with about 620 being the point below which consumers may be regarded as high-risk FICO scores can vary by as much as 50 points between credit reporting agencies

Book Work “Checkpoints”  Pg. 201 & 205 Ch. 7.3 Assessment  Pg. 206 #1-4

Dave Ramsey Credit Bureaus Test & Sample Credit Report Activity