Annual Credit Review
An annual assessment conducted by lenders and creditors on customers with an outstanding loan or credit lines
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What is an Annual Credit Review?
An annual credit review is a review process that lenders conduct on current accounts with outstanding credit. Creditors, such as banks, credit bureaus, and financial services companies conduct assessments on both individual and corporate customers to assess their risk level and their ability to continually honor outstanding credit obligations. Based on the credit review findings, the creditor can make decisions on whether to extend credit or cease any existing relationships with the customer.
In the commercial lending industry, credit review takes the form of an account monitoring, where the lender reviews current outstanding loans on a periodic basis, either quarterly, semi-annually, or annually. The goal of the review is to ensure that all the outstanding loans were provided according to the company’s standards and rules. The lender also verifies the non-deterioration of creditworthiness of the borrowers with outstanding credit lines.
Summary
- An annual credit review is an annual assessment conducted by lenders and creditors on customers with an outstanding loan or credit line.
- The findings of the credit review help the lender make a decision on whether to extend credit or cease extending credit to the borrower.
- Lenders also conduct credit reviews to determine if customers with outstanding credit meet the existing lending criteria and standards.
Purposes of Annual Credit Review
The following are the main reasons why lenders and creditors conduct an annual credit review:
1. Evaluate the creditworthiness of potential borrowers
A creditor can use the credit review as a tool for assessing a customer’s ability to make principal and interest payments on time. For existing customers with outstanding loans, the creditor is interested in knowing whether they still meet the loan requirements and lending criteria and if their financial circumstances could’ve changed.
The findings can help the creditor review the credit lines with the goal of increasing or reducing the amounts available to the customer (s). The creditor can also assess the financial strength of new borrowers to determine their ability to pay back the loan amount plus interest in a timely manner.
Depending on the findings of the evaluations, the lender can decide to approve or reject the loan application.
2. Examine prospective borrower’s credit history
Creditors can also conduct credit reviews with the goal of examining the credit history of a borrower to know their track record in terms of the amount of credit they have borrowed in the past, payment patterns, history of defaults and foreclosures, etc. The lender can obtain the credit report from one of the three main credit bureaus, i.e., Transunion, Experian, and Equifax.
The credit report provides information about all the lenders that have extended credit to the customer, payment history, credit limits, and the consistency in making timely payment across the different creditors. The lender can then use the information to make a decision on whether to approve or reject the loan application, depending on the assessed risk level and past credit history.
3. Reveal negative data about borrowers
The creditor can also use the annual credit review to scrutinize a borrower’s financial status to find out negative information relating to their previous credit history. For example, if the lender finds that a borrower with an outstanding loan has a history of bankruptcy filings, monetary judgments, foreclosures, etc., the credit line may need to be re-evaluated to reflect the new information.
The presence of negative information in a borrower’s credit report presents an increased risk to the lender, and the lender may choose to reject further loan applications or reduce the credit line available to the borrower.
Information Collected During Annual Credit Review
When lenders are extending credit for different types of loans, such as mortgages, auto loans, and personal loans, they collect specific types of data about the borrower during the credit review. The lender analyzes the borrower’s financial statements to get an idea of the capital structure, management performance, inventory turnover rates, retained earnings, existing short-term and long-term liabilities, etc.
Most lenders are interested in collecting the following information during credit review:
1. Adequacy of collateral
When conducting an annual credit review, the lender is interested in knowing the adequacy of the collateral pledged for the loan. Specifically, the lender determines if the fair value of the collateral is enough to cover the total amount of loan in case the borrower defaults.
If the borrower’s valuation of collateral is not satisfactory, the lender can institute an independent valuation of the asset to determine its estimated value after taking into account the depreciation costs. The lender may also verify the ownership of the collateral by requiring the borrower to provide proof of ownership documents, such as title deed, logbook, etc.
2. Capital
When extending credit to a borrower, the lender may give preference to borrowers with reserve capital from savings, investments, or real estate. The reserve capital can be used to repay the loan in case the business/activity being funded fails.
For personal loans, lenders can easily approve credit to individuals with an additional source of capital apart from the household income. The availability of extra capital may also demonstrate the ability of a borrower to manage their finances efficiently.
3. Loan purpose
Credit review may involve looking at the purpose of the loan or how the borrower intends to use the funds. The lender is interested in funding feasible projects that will earn enough return to help finance the loan. If the purpose of the loan is not feasible or not indicated, there is a higher risk of the lender defaulting, and the lender may reject the application.
Also, where the purpose of the loan is to finance a project with a social impact on the community, the lender may accept to extend credit based on the social impact of the project on the community.
Related Readings
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
