CREDIT APPROVAL



Credit approval is the process a business or an individual undergoes to become eligible for a loan or pay for goods and services over an extended period. Granting credit approval depends on the willingness of the creditor to lend money in the current economy and that same lender's assessment of the ability and willingness of the borrower to return the money or pay for the goods obtained—plus interest—in a timely fashion. Typically, businesses seek approval to obtain loans and also grant approval for loans to their customers.

The term credit is derived from the Latin credo, " I believe" or "I trust." Credit implies a condition of trust between borrower and lender that the funds (or goods) lent will be repaid. In the past, when the economy operated on a simpler basis and Biblical prohibitions against usury were taken more seriously, a person would lend money to a friend on trust. The success of this arrangement depended upon the assessment of the friend's creditworthiness, a situation summed up by Shakespeare as "Neither a borrower, nor a lender be." There were also people, known as money lenders, who were willing to extend credit and to charge interest on the loans they made. In the late Middle Ages and early Renaissance, the foundations of the modern banking system developed in Italy. The impersonalization of credit and the availability of investment capital have helped provide the large sums of money necessary for modern business expansion.

There are three general types of business loans, the short-term loan, the long-term loan, and equity capital funding. A short term loan is usually undertaken for a year or two and is often repaid by liquidation of assets or from earnings. Often such a loan is granted on a "signature" basis, that is, without collateral. In such cases, the credit history of the individual or firm making the application is enough to fix the bond of trust. A longer term loan is usually repaid from earnings over time and is usually undertaken for larger improvements. Long-term loans are often secured, that is, guaranteed by the pledge of assets or other collateral; if repayment is missed then the person granting credit becomes the owner of whatever assets were pledged. In equity capital funding, money is raised by selling interest or shares in the company. The credit approval process used by potential investors to determine the value of the stock includes the ratio of the net worth of debt to the assets, the quarterly earnings of the company, the value and condition of any collateral, the borrower's management ability and character, and the future prospects of the company and the industry. Robert Morris Associates, an association of credit and risk management professionals established in 1983, also recommends that bankers engaged in equity capital funding also consider asset and liability management, investment control and oversight, and ownership of risk in extending loans. The selling of stock is also a form of equity financing, wherein the future success of the business becomes the asset pledged.

To establish its credentials for any credit approval process, from short-term loans to equity funding, a firm needs to have a business plan and a good credit history. The company must be able to show that it can repay the loan at the established interest rate, as well as be prepared to establish that the outlook for business in general and for its type of business in particular supports their future projects and the reasons for their borrowing. The process of granting loans to businesses is regulated by the Federal Trade Commission (FTC) to ensure fairness and guarantee nondiscrimination and disclosure of all aspects of the process.

The Small Business Administration (SBA) publishes a series of pamphlets and other information designed to assist businesses in obtaining loans. These publications advise businesses on a range of credit approval topics including describing assets, preparing a business plan, and determining what questions to expect and how to prepare responses to those questions.

Businesses also issue credit approval for their customers. Despite the prevalence of national credit cards, many stores offer their own individual credit approval terms for purchases of goods and services. The process by which a store grants credit to individuals is governed by laws—administered by the Federal Trade Commission—that guarantee nondiscrimination and other benefits. These laws include the Equal Credit Opportunity Act, Fair Credit Reporting Act, Truth in Lending Act, and Fair Debt Collection Practices Act.

To approve credit for a customer, a firm often requests credit references. In a shortened form of credit approval ("instant credit" in the retail trade), a client provides credit references in the form of a bank account number and another credit card. The fact that others consider the client creditworthy becomes the basis for the business in question to extend credit for purchases up to a certain amount. The customer's social security number is often used for identification purposes in this process.

It would be difficult for every business to investigate every aspect of the credit record of an individual customer in today's society. Many businesses and banks use the services of a credit bureau to assess the credit rating of applicants. Three credit bureaus—Equifax, Experian, and TransUnion—collectively hold the personal credit histories of all U.S. citizens. Credit bureaus use an individual's social security number to obtain information and maintain a record of every request for credit a person makes, as well as their timeliness in debt repayment. Individuals' rights in the credit approval process are protected by the FTC, and credit history information can be released only with an individual's permission. Despite federal oversight, the information provided by credit bureaus is often incorrect. In a National Association of Independent Credit Reporting Agencies survey conducted in 1994, 19 percent of credit reports were found to contain outdated information, and 44 percent were found to lack information regarding current balances and payments on existing loans. In response to this inaccuracy, banks and other lenders are increasingly turning to in-house credit information services to provide credit approval.

Lenders are also making increased use of new techniques and technologies to evaluate loan applicants and business and financial prospects. Data mining, for instance, is used by banks to analyze large pools of information and obtain insight into general trends including potential new customers and fraudulent transaction patterns. Large lending institutions also place increasing reliance on computerized loan underwriting systems. The Bank of America established a computerized data imaging network in 1997, allowing the bank to process 20,000 credit applications per day. Two of the nation's largest home loan providers, PMI Mortgage Insurance Company (PMI) and Fannie Mae (formerly, the Federal National Mortgage Association), applied in the fall of 1998 for Federal Housing Administration approval for their use of automated loan underwriting systems, which PMI had used on a limited trial basis since 1993.

[ Joan Leotta ,

updated by Grant Eldridge ]

FURTHER READING:

"Credit: B of A Accelerates Credit Application Approval." American Banker, 12 May 1997, S26.

Decker, Paul. "Data Mining's Hidden Dangers." Banking Strategies 74, no. 2 (March-April 1998): 6.

Federal Reserve System. Board of Governors. Consumer Handbook to Credit Protection Laws. Washington: Federal Reserve System, 1993. Available from www.pueblo.gsa.gov/cic_text/money/protection-laws/ccredit.txt .

Hosmer, LaRue T. A Venture Capital Primer for Small Business. Washington: U.S. Small Business Administration, Management Assistance, Support Services Section, 1982. Inadomi, Kenneth. "What You Need to Know before You Pull a Credit Report." Real Estate Today, February 1995, 33.

Toth, Terence J. "The Robert Morris Guide for Investment of Cash Collateral." American Banker, 6 July 1995, 5.

U.S. Federal Trade Commission. "Federal Trade Commission." Washington: U.S. Federal Trade Commission, 1999. Available from www.ftc.gov .

U.S. Small Business Administration. The ABC's of Borrowing. Washington: U.S. Small Business Administration, 1989. "What's the Score at FHA?" ABA Banking Journal 90, no. 10 (October 1998): 54.



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