Definition and Example of a Nonperforming Loan
Most banks and lenders in the U.S. consider a loan to be nonperforming when a borrower hasn’t made principal and interest payments for more than 90 days. Once a loan becomes nonperforming, the chance of default by the borrower increases significantly.
Acronym: NPL
For example, let’s say you take out a $10,000 personal loan to cover a medical bill. You agree to make a $1,000 payment by the last day of every month. If you were to lose your job and not make payments for 100 days, your personal loan would be considered a nonperforming loan.
How a Nonperforming Loan Works
While it depends on the terms of the agreement, the lender, and even the country, most loans are considered to be nonperforming if payments are more than 90 days past due. They are usually considered in default or close to default at that time, depending on the lender. If payments resume, the nonperforming loan turns into a reperforming loan. This occurs even if the borrower is not completely caught up on their payments. Banks and other lenders may sell nonperforming loans to get rid of risky assets on their balance sheets. They can sell them to asset management companies (AMCs), which buy pooled funds from clients and invest them into various securities and assets. Another option for banks is to sell their nonperforming loans to collection agencies at discounted rates. By selling them, banks can recover at least a portion of the funds they lost.
Types of Nonperforming Loans
A loan is usually considered a nonperforming loan if principal and interest payments are at least 90 days past due and the lender believes the borrower will not be able to repay their loan. If this is the case, the lender will write it off as a bad debt. If changes in the loan agreement lead to payments that are 90 days capitalized, refinanced, or delayed, the loan is also considered nonperforming. In addition, if payments are less than 90 days overdue but the lender has reason to believe the borrower won’t repay the loan in full, the loan will be put in the nonperforming category as well.
The Impact of Nonperforming Loans on Banks
Lenders earn a bulk of their money from the interest they charge on their loans. While banks and lenders usually have a reserve of money to help cushion losses, if they can’t collect the interest payments they’re owed, they may be at risk of paying for operating costs and distributing new loans. Banks must report their ratio of nonperforming loans, and this ratio measures their loan quality and level of credit risk. An excessive amount of nonperforming loans can deter investments from lenders. It may also lead to close monitoring by the Federal Deposit Insurance Corporation (FDIC), which protects those in risky funding situations.
