What Are Bad Loans?

. 5 min read
What Are Bad Loans?

Bad loans may sound a bit odd to anyone who has not come across this phrase, but it does exist. It is widely known as a non-performing loan or an NPL. Any debt can become a bad loan when the borrower has not been able to repay the monthly interest or principal for a specific period. This happens when the borrower runs out of money to repay or faces a situation that makes it challenging for him/her to repay.

When Is It Considered As A Bad Loan?

The next question that pops up in your mind might be - after how many months of failure to repay, will a loan be termed a bad loan. There is, however, no definite rule for this. Every bank or lender has a different time limit to declare a bank loan non-performing. Usually, after 90 continuous days of failure to repay, banks declare the debt as a bad loan or non-profit loan. This may vary as per the agreement and terms of the loan. When a loan is classified as a bad loan, the likelihood of receiving any repayment from the borrower is considered low. However, the borrower can start repaying the loan, interest, or monthly principal, even after the loan is classified as an NPL. Once the borrower resumes repaying the interest, the loan will be considered as a reperforming loan.

What are the Types of Bad Loan?

A loan becomes a bad loan based on its type and nature. Here are the reasons for a loan becoming a bad loan or an NPL –

  • The loan instalments are due for a minimum of 90 days, and the bank or the lender believes that the loan will not be repaid. This will lead the lender to declare the loan a bad loan.
  • The interest repayments of 90 days or more are refinanced, delayed, or capitalised due to the transition of the agreement and the terms of the loan.
  • Any other reason/s that indicate the borrower's inability or unwillingness to repay the loan in full even when there are less than 90 days due to repayment.

What Does A Bank Do After Classifying a Loan as an NPL?

One of the many steps a bank takes when they classify a loan as bad is that they reclaim the possessions pledged as surety or sell the loan to collecting agencies. This helps the bank maintain its cash flow.

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1. Impact of Bad Loans on Banks

One or two bad loans of small amounts do not affect the bank. The problem arises when there are too many bad loans adding up to a huge amount. This can affect the cash flow of the bank. In other words, when the bank or the lender classifies a large number of loans as NPL, they may face financial problems. This may even push a bank towards bankruptcy. Let's discuss the impact of bad loans in detail.

Banks benefit from the interest that each loan brings. When they do not receive the interest on the loan, and when the amount is huge, they are bound to suffer a major financial crisis. Banks or lenders become unable to offer new loans, which affects their income.

A bank with too many bad loans or bad loans amounting to a huge sum may be on its way to bankruptcy. Banks have investors who are affected by too many bad loans. The stock price of the bank or the lender goes down when the total bad loans go up. This hurts the reputation of the bank or the lender. New investors will not choose a bank with too many NPLs.

No matter what, bad loans impact the bank or the lender adversely. A single bad loan of a huge percentage can also hurt the bank's financial status at large.

Moreover, banks have to report the ratio of their NPL to total loans to the central bank. The government requires all the banks and money lenders to do so. This determines the credit risk of the bank and the nature of any outstanding loan.

Any bank with a high ratio of non-performing assets is marked risky.

2. Impact On the Borrower

Borrowers face multiple problems when they are unable to repay their loans on time. A borrower is issued a 60-day notice if payment has been due for 90 days or more. A borrower has to repay the money within these 60 days, failing which the bank or the lender will be forced to sell their assets.

The credit score of a borrower gets affected if they have one or more bad loans to their name. This also makes the borrower less likely to get a new loan from any bank or lender.

How Lenders Tackle Non-Performing Loans

The NPLs are considered bad loans by the lender because the chances of loan recovery are low, let alone the loan's interest. Bad loans affect the bank adversely and in ways that are usually irreversible. Banks may take certain steps to recover the number of bad loans.

One of the things that banks can do to recover bad loans is to sell the borrower's assets pledged as collateral for their loan. For instance, if the borrower has kept their apartment or a piece of land as collateral, the lender will sell the land or the apartment. As a result of a borrower failing to repay the loan amount along with interest, a lender can foreclose the property.

The bank or lender may also sell off the non-performing loans to their collection agencies. The lenders may even sell it to outside investors. Non-profit loans are risky assets. Hence, banks choose to sell them to get them off of their balance sheet. They sell off non-performing loans or bad loans at a considerable discount to collection agencies. This helps the lender recover the loan money and salvage its reputation. Lenders/ banks approach collection agencies only when they want to recover their bad loans.

Who Is at Greater Risk of Owning a Bad Loan to a Bank?

Needless to say, people lend money for many reasons. A borrower must pay his/her loan on time. Not being able to repay the loan and interest amount for over 90 days forces a lender to consider such loans bad. This will have an adverse impact on the credit score of borrowers. Thus, the next time a defaulting borrower applies for a loan, the lender will be less likely to approve it.

This can affect small to midsize business owners as such businesses frequently require funds. A bad loan will reduce their chances of getting any future loans.

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Closing Thoughts

Bad loans or non-performing loans can hurt both the lender and the borrower to a great extent. Thus, borrowers need to pay off the loan on time or take loans only if they can repay it in time.

Also read:

1) How To Get Small Business Loan From Government?
2) What is Business Loan? A Complete Guide.
3) What is a business loan? How to apply for a business loan?
4) Home Loan: Steps to apply, Best Interest Rates on Home Loans & more