Understanding Loan Classifications

While taking out a loan to buy a home is so common that no one thinks twice about submitting a lender’s application, very few borrowers actually understand how their loans are classified and the criteria that place them within a specific category. From typical loans to those that are rarely heard of, understanding how a loan is classified may impact the borrower’s decision about accepting the loan.

5 Loan Classifications

Although the phrase, “loan classification” is often misunderstood, current or future borrowers should know that it actually refers to the likelihood of the loan and any associated interest being repaid on time and in full. Non-adverse and adverse classifications are assigned to each loan based on certain qualities of the borrower and his or her financial health and assets.

Non-adverse loan classifications include pass and special mention loans. A pass loan classification refers to a loan on which lenders can expect full repayment of both the principle and the interest; this is optimal for the lender. Similarly, the special mention loan is not adversely classified; however, this classification is used when certain risk factors could impact repayment potential if lenders proceed without taking the appropriate measures to protect their investment.

There are also several types of adverse loan classifications, one of the most common being the substandard loan. When lenders assign a substandard classification to a loan, it implies that they are taking a risk in lending the money because the borrower has not demonstrated enough income, credit worthiness or collateral to make the lender believe that he or she will not struggle with repayment. A doubtful loan classification is very similar to substandard; the factors impacting this classification are those which make it highly unlikely that the lender will ever be able to collect on the principle and interest of the loan. Finally, a loss is a classification that makes it virtually worthless for the lender to continue to attempt to collect on the loan. This is often applicable to situations where default has occurred and collection efforts have not been remotely successful.

Classifications Impact Borrowers

Understanding potential loan classifications before applying for a home loan may prepare future borrowers for higher interest rates, excessive scrutiny or even denial of a credit application. Ensuring that one’s credit and income are in order before applying for a home loan may make it easier to secure the loan.