Nonperforming loans (NPLs) are loans where borrowers have failed to make scheduled payments for an extended period, typically 90 or 180 days. In this comprehensive guide, we’ll explore what NPLs are, the various types, causes, and the impact they have on the financial landscape. Whether you’re a borrower, lender, or investor, understanding NPLs is crucial for making informed financial decisions.
Understanding nonperforming loans (NPLs)
A nonperforming loan (NPL) is a loan that is in default due to the fact that the borrower has not made the scheduled payments for a specified period. Although the exact elements of nonperforming status can vary depending on the specific loan’s terms, “no payment” is usually defined as zero payments of either principal or interest.
How a nonperforming loan (NPL) works
A nonperforming loan (NPL) is considered in default or close to default. Once a loan is nonperforming, the odds the debtor will repay it in full are substantially lower. If the debtor resumes payments again on an NPL, it becomes a reperforming loan (RPL), even if the debtor has not caught up on all the missed payments.
In banking, commercial loans are considered nonperforming if the debtor has made zero payments of interest or principal within 90 days, or is 90 days past due. For a consumer loan, 180 days past due classifies it as an NPL.
A loan is in arrears when principal or interest payments are late or missed. A loan is in default when the lender considers the loan agreement to be broken and the debtor is unable to meet the obligations.
Types of nonperforming loans (NPLs)
A debt can achieve nonperforming loan status in several ways. Examples of NPLs include:
1. A loan in which 90 days’ worth of interest has been capitalized, refinanced, or delayed due to an agreement or an amendment to the original agreement.
2. A loan in which payments are less than 90 days late, but the lender no longer believes the debtor will make future payments.
3. A loan in which the maturity date of principal repayment has occurred, but some fraction of the loan remains outstanding.
The Fair Debt Collection Practices Act prohibits certain abusive or deceptive practices in order to collect on nonperforming personal loans. However, this law only applies to third-party debt collectors or debt investors, not the original lender.
Official definitions of nonperforming loans (NPLs)
Several international financial authorities offer specific guidelines for determining nonperforming loans.
The European Central Bank (ECB) requires asset and definition comparability to evaluate risk exposures across euro area central banks. The ECB specifies multiple criteria that can cause an NPL classification when it performs stress tests on participating banks. The ECB has performed a comprehensive assessment and developed criteria to define loans as nonperforming if they are:
– 90 days past due, even if they are not defaulted or impaired.
– Impaired with respect to the accounting specifics for U.S. GAAP and International Financial Reporting Standards (IFRS) banks.
– In default according to the Capital Requirements Regulation.
An addendum, issued in 2018, specified the time frame for lenders to set aside funds to cover nonperforming loans: two to seven years, depending on whether the loan was secured or not. As of 2020, eurozone lenders still have approximately $1 trillion worth of nonperforming loans on their books.
The International Monetary Fund (IMF) also sets out multiple criteria for nonperforming government loans.
The IMF has defined nonperforming loans as those whose:
– Debtors have not paid interest or principal payments in at least 90 days or more.
– Interest payments equal to 90 days or more have been capitalized, refinanced, or delayed by agreement.
– Payments have been delayed by less than 90 days, but come with high uncertainty or no certainty the debtor will make payments in the future.
Nonperforming loan (NPL) vs. reperforming loan (RPL)
Nonperforming loans are those in default. Reperforming loans are those that were once nonperforming and are now performing again. The reperforming loans were once delinquent for at least 90 days and are now performing again.
Reperforming loans are often loans where the borrower has filed for bankruptcy and has continued to make payments as a result of the bankruptcy agreement. Such an agreement generally allows the borrower to become current on their debt via a loan modification program.
Example of a nonperforming loan (NPL)
Imagine a hypothetical borrower who cannot make loan payments due to job loss. After 90 days without payment, the bank or lender will consider the loan nonperforming. The bank would shift the loan to their nonperforming list and continue seeking payment for the debt.
There are multiple avenues available to the creditor. One of the most common ways to collect the debt is to send it to a collections agency, which will be paid a percentage of any money they recover. The lender can also sell the debt to a debt buyer at a fraction of the face value. Although the creditor will lose money, this is often a better financial choice than trying to collect on a nonperforming loan.
Borrowers with nonperforming loans may be able to negotiate with creditors to forgive part of their debt. However, this may damage their credit rating, making it harder and more expensive to borrow in the future.
What happens to nonperforming loans?
Nonperforming loans can be sold by banks to other banks or investors. The loan may also become reperforming if the borrower starts making payments again. In other cases, the lender may repossess the borrower’s collateral to satisfy the loan balance.
What are the causes of nonperforming loans?
Nonperforming loans tend to occur during economic hardships when delinquencies are high. They happen when the borrower fails to make a payment for a long period of time (such as 90 to 180 days).
Why do banks sell nonperforming loans?
Banks may sell nonperforming loans to focus on the loans that bring in money each month. Selling the loans at a discount may be more profitable than trying to collect money from a delinquent borrower.
Who buys nonperforming loans?
Other banks or distressed debt investors may consider investing in nonperforming loans, as well as real estate investors.
How do you solve a nonperforming loan?
Solving a nonperforming loan involves getting back on track with payments. This is may be
done with a loan modification agreement through the lender.
Implications of Nonperforming Loans
Nonperforming loans can have far-reaching implications, affecting not only borrowers but also financial institutions and the economy as a whole.
Impact on borrowers
Borrowers with nonperforming loans may face severe consequences, including:
– Damage to their credit score, making it difficult to secure credit in the future.
– Potential legal actions and collection efforts from lenders or third-party debt collectors.
– Difficulty in achieving financial stability, as nonperforming loans can lead to a cycle of debt.
Impact on financial institutions
For financial institutions, nonperforming loans represent a significant risk:
– Reduced profitability due to potential losses on nonperforming loans.
– Increased capital requirements to cover the potential losses.
– Reputational damage if a bank has a high number of nonperforming loans.
Impact on the economy
On a broader scale, nonperforming loans can impact the overall economy:
– They can strain the stability of the financial system if they reach a critical mass.
– Economic growth may be hindered if a large number of loans become nonperforming during economic downturns.
Common causes of nonperforming loans
Nonperforming loans can result from various situations. Here are some common causes:
Economic recessions or downturns often lead to job losses, reduced income, and financial instability. In such situations, borrowers may struggle to meet their loan obligations, causing loans to become nonperforming. This phenomenon was evident during the global financial crisis of 2008 when a significant number of mortgages turned nonperforming.
Inadequate credit assessment
Sometimes, nonperforming loans can be traced back to the lender’s inadequate assessment of the borrower’s creditworthiness. When banks and financial institutions fail to accurately evaluate a borrower’s ability to repay, loans are more likely to become nonperforming. For example, issuing loans without verifying income or employment can result in defaults.
Real-life examples of nonperforming loans
Understanding nonperforming loans is easier with real-life examples:
The mortgage meltdown (2008)
One of the most significant instances of nonperforming loans occurred during the 2008 financial crisis. Many homeowners who took out adjustable-rate mortgages found themselves unable to make higher monthly payments when interest rates increased. This led to a surge in mortgage defaults and nonperforming loans, ultimately contributing to the economic downturn.
The European debt crisis (2010-2012)
The European debt crisis saw several European countries struggling with unsustainable levels of government debt. As government bonds faced the risk of default, financial institutions holding these bonds experienced a surge in nonperforming loans. The crisis highlighted the interconnectedness of government debt, financial institutions, and the broader economy.
Nonperforming loans are a critical aspect of the financial world, affecting borrowers, lenders, and the economy at large. Understanding the causes and consequences of nonperforming loans is essential for making informed financial decisions. Whether you’re an individual borrower or a financial institution, being aware of NPLs’ implications can help you navigate the complex landscape of debt and credit.
Frequently Asked Questions
What is the definition of a nonperforming loan (NPL)?
A nonperforming loan (NPL) is a loan in which the borrower has failed to make the scheduled payments for a specified period. Generally, it’s defined as zero payments of either principal or interest for a specific duration, which can vary based on the type of loan and the industry, but is often 90 or 180 days.
How does a nonperforming loan (NPL) work?
A nonperforming loan is considered in default or close to default, with a significantly lower likelihood that the debtor will repay it in full. If the debtor resumes payments, even if they haven’t caught up on all the missed payments, the loan becomes a reperforming loan (RPL). The specific criteria for nonperforming status can vary between commercial and consumer loans.
What are the official definitions of nonperforming loans (NPLs) by financial authorities?
Various financial authorities, such as the European Central Bank (ECB) and the International Monetary Fund (IMF), have defined nonperforming loans based on specific criteria. The ECB, for example, considers loans as NPLs when they are 90 days past due, among other criteria. The IMF, on the other hand, defines NPLs based on factors like the length of delinquency and the certainty of future payments.
What are the implications of nonperforming loans for borrowers and financial institutions?
Nonperforming loans can have severe consequences for borrowers, including damage to their credit scores, potential legal actions, and difficulties in achieving financial stability. For financial institutions, nonperforming loans represent a significant risk, leading to reduced profitability and increased capital requirements.
Why do banks sell nonperforming loans, and who buys them?
Banks may sell nonperforming loans to focus on more profitable loans and avoid the challenges of collecting from delinquent borrowers. Other banks and distressed debt investors are common buyers of nonperforming loans, as well as real estate investors.
What are some common causes of nonperforming loans?
Nonperforming loans can result from various situations, with economic downturns and inadequate credit assessment being common causes. Economic recessions can lead to job losses and reduced income, making it challenging for borrowers to meet their loan obligations. Inadequate credit assessments by lenders, such as failing to verify income or employment, can also result in defaults and nonperforming loans.
- Nonperforming loans (NPLs) are loans in which borrowers have failed to make scheduled payments for an extended period, typically 90 or 180 days.
- Nonperforming loans can have severe consequences for borrowers, including damage to their credit scores and potential legal actions.
- For financial institutions, nonperforming loans represent a significant risk, leading to reduced profitability and increased capital requirements.
- Nonperforming loans can impact the overall economy by straining the stability of the financial system and hindering economic growth.
View Article Sources
- Non-Performing and Re-Performing Loan Sales – fhfa.gov
- Regulations, Governance, and Resolution of Non-Performing … – Sacred Heart University
- What are non-performing loans (NPLs)? – ECB Banking Supervision