Nonperforming Loan

Definition

A nonperforming loan (NPL) is a loan in which the borrower is in default and has not made scheduled payments of principal or interest for a specified period, typically 90 days or more. The loan can also be considered nonperforming if the maturity date has been reached and the loan remains unpaid.

Examples

Example 1: A homeowner took out a mortgage but has stopped making monthly payments for over three months. The lending bank classifies this mortgage as a nonperforming loan because the borrower has exceeded the 90-day period without making any payments.
Example 2: A company took a business loan with quarterly repayment terms. The due date passed over three months ago, and no payment has been made. This commercial loan becomes classified as nonperforming.
Example 3: An individual with a personal loan has a history of missed payments and has been delinquent for more than 90 days. The financial institution holding the loan now considers it as a nonperforming loan.

Frequently Asked Questions (FAQ)

What happens when a loan becomes nonperforming?

When a loan is classified as nonperforming, the lender may take actions such as restructuring the loan, initiating foreclosure or repossession proceedings, writing off the loan as bad debt, or selling the loan to a collection agency.

How can NPLs impact a bank’s financial health?

High levels of nonperforming loans can significantly impact a bank’s profitability and solvency. The bank may need to set aside capital reserves to cover potential losses, which can reduce the funds available for new lending and investment.

Are nonperforming loans the same as bad debts?

Not necessarily. While all bad debts are nonperforming, not all nonperforming loans are definitively classified as bad debts. A nonperforming loan still holds the potential for repayment or restructuring, whereas bad debt often represents an irrecoverable loss.

What are some common strategies to manage nonperforming loans?

Banks can manage NPLs through loan restructuring, enhanced collection efforts, strengthened credit review processes, and sometimes by selling the nonperforming loans to third-party investors specialized in distressed assets management.

Why is the 90-day delinquency period significant for NPL classification?

The 90-day period serves as a standard benchmark in banking for identifying loans at a high risk of default. It helps in the early identification of potential credit risks and triggers corrective actions from lenders.

Delinquent Loan: A loan that is past due on payment but has not yet reached the threshold to be classified as nonperforming, generally less than 90 days overdue.
Foreclosure: The legal process by which a lender takes control of a property to recover the outstanding loan amount after the borrower fails to make required payments.
Bad Debt: An amount that has been written off by the creditor as a loss because it is deemed uncollectible.
Credit Risk: The risk of loss arising from a borrower’s failure to repay a loan or meet contractual obligations.
Loan Restructuring: Modifying the original terms of a loan agreement, typically to defer repayments, reduce interest rates, or extend maturity dates to assist borrowers in difficult financial situations.

Online Resources

References

“Bank Regulation: Understanding NPLs and Credit Risk Management” by John Smith.
“Principles of Banking: Key Topics for NPLs” in the Journal of Financial Stability, 2020.
Reports from the Office of the Comptroller of the Currency (OCC).

Suggested Books for Further Studies

“Risk Management and Financial Institutions” by John C. Hull
“Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms” by Anthony Saunders and Linda Allen
“Managing Credit Risk: The Next Great Financial Challenge” by John B. Caouette, Edward I. Altman, Paul Narayanan

Real Estate Basics: Nonperforming Loan Fundamentals Quiz

### What period is generally used to classify a loan as nonperforming? - [ ] 30 days delinquent - [ ] 60 days delinquent - [x] 90 days delinquent - [ ] 120 days delinquent > **Explanation:** A loan is generally classified as nonperforming when it is 90 days or more past due on payments. ### Can interest payments alone prevent a loan from becoming nonperforming? - [ ] Yes, as long as interest is paid. - [x] No, principal payments must also be made. - [ ] Only late fees are relevant. - [ ] It depends on the loan type. > **Explanation:** Both interest and principal payments need to be made; failing on either can classify a loan as nonperforming. ### NPLs primarily affect a bank how? - [ ] By increasing their net profit - [ ] By improving liquidity - [x] By reducing profitability and increasing risk - [ ] By expanding their customer base > **Explanation:** NPLs reduce a bank's profitability and increase its financial risks, potentially leading to issues in capital reserves. ### Which loans may often need to be written off as bad debts? - [x] Nonperforming loans that have no repayment prospect - [ ] Current loans - [ ] Fully repaid loans - [ ] Guaranteed loans > **Explanation:** Nonperforming loans with no repayment prospect are often written off as bad debts after all recovery avenues fail. ### When does a lender typically begin foreclosure? - [ ] Immediately when a payment is missed - [x] After a loan becomes nonperforming - [ ] When a borrower requests it - [ ] Within the first 30 days of delinquency > **Explanation:** Foreclosure proceedings usually begin after a loan has been classified as nonperforming, indicating severe payment issues. ### Which entity may give a targeted assessment for NPL classification? - [ ] Borrower’s accountant - [ ] Stockholders - [x] Bank examiner - [ ] Sales department > **Explanation:** A bank examiner assesses loans for classification as nonperforming, looking at financial health and payment records. ### What might a bank do to manage a rising level of NPLs? - [ ] Suspend all lending activities - [x] Restructure loans and enhance collections - [ ] Increase loan interest rates - [ ] Decrease asset holdings > **Explanation:** Banks may manage rising NPLs by restructuring loans, enhancing collection efforts, or selling distressed loans. ### The 90-day rule for NPL classification is intended to help with what? - [ ] Increasing portfolio growth - [ ] Reducing asset quality - [x] Identifying credit risk early - [ ] Boosting total repayments > **Explanation:** The 90-day rule helps in early identification of credit risk, prompting timely corrective actions. ### An NPL impacts the balance sheet primarily how? - [ ] It enhances asset liquidity. - [x] It increases the loan loss provisions. - [ ] It improves equity. - [ ] It decreases liabilities. > **Explanation:** Nonperforming loans increase the loan loss provisions, reflecting potential future losses on the balance sheet. ### Which department within a bank frequently reviews nonperforming loans? - [ ] Marketing - [ ] Human Resources - [x] Risk Management - [ ] Customer Service > **Explanation:** The risk management department frequently reviews and manages nonperforming loans to mitigate financial losses.