Classified loans, issued by banks or other lenders, are loans that are likely to end up in default. Borrowers do not have to be behind on payments for a loan to be classified, but the loan must be substandard in some way, or unlikely to be paid back for some specific reason.
Definition and Examples of Classified Loans
When lenders develop a portfolio of loans, they generally need to keep track of outstanding balances as well as the likelihood of repayment. If they have loans on the books that are in danger of default, either because they are past due or because there are other problems, the loans may be classified.
The Uniform Retail Credit Classification and Account Management Policy sets standards for when certain consumer loans and credit card accounts must be classified. In some cases, though, individual financial institutions are allowed to be more conservative in their classification rules.
In general, if open- or closed-ended retail loans are at least 90 days past due, the loans should be classified as substandard under the Uniform Policy. However, loans could also be classified as substandard for other reasons, such as if borrowers have low credit scores or if they spend beyond their borrower limits.
For example, say a borrower has not paid on a loan for 100 days. That would be considered a classified loan, as would a loan where a borrower has only made small partial payments for more than 90 days. When a loan is classified, it is reported on the lender’s accounting records with its classification status.
Consumers who are late in paying loans face serious consequences. Creditors generally report late payments to credit reporting agencies, resulting in a reduction in consumer credit scores. Borrowers may also be charged late fees and penalties.
How Do Classified Loans Work?
A lender will generally classify a loan when there is a high probability that the borrower will not pay back the designated amount at hand. There are several cases of when a lender would need to classify a loan, including:
- If a borrower fails to make a payment on a loan for 90 days
- If a borrower files for bankruptcy
- If a lender passes away
Lenders may classify loans in other circumstances if there is reason to believe that the loan will not be paid back, too. While lenders generally screen borrowers and review their financial credentials before applying for a loan, there are situations where borrower circumstances change and lenders become concerned about nonpayment. In this case, lenders would classify a loan.
Some lenders have more conservative standards for classification than others do. It's possible that one lender will make a loan, and another will subsequently take over that lender's portfolio and later decide the loan was a high-risk one that should be classified. Be sure to confirm your lender’s policy prior to receiving a loan.
If a loan is likely to be paid back, lenders do not have to classify a loan, even if it is delinquent. An example of this would be a mortgage loan for an amount that is well below the value of the home. Because the lender could collect payment by foreclosing and selling the property, the loan does not have to be classified.
Types of Classified Loans
Any type of loan could be classified, including open- and closed-ended consumer loans. Home loans, car loans, and credit cards are some of the different kinds of loans that could be classified if lenders have reason to believe the accounts will not be paid.
Open-ended loans enable you to borrow more than once, with the most common kinds being credit cards and lines of credit. Closed-ended loans are one-time loans, meaning once they’ve been repaid, they cannot be borrowed again. Examples include student loans or mortgages.
There are three classification statuses for classified loans.
- Substandard: These are loans that are not likely to be paid back but are not yet in default. This type of loan is characterized by the possibility that the bank will sustain some or total loss if the money is not paid.
- Doubtful: While similar to substandard, classified loans of this kind receive this designation if the ability by the borrower to pay in full is “highly questionable and improbable.”
- Loss: A loan with this designation will definitely not be paid back in the eyes of the lender. In this case, lenders can charge them off. Charge-offs mean the lender has written off the uncollectible debt after attempts to collect have failed. When a loan has been charged off, the value of the loan is no longer on the lender's books.
Government regulations require lenders to have retail-lending credit policies in place to ensure they are managing risk soundly. Regularly reviewing loan classifications should be a part of each lender's policy.
- Classified loans are loans that are in danger of not being paid back.
- When classifying loans, there are uniform classification standards, but lenders can be more conservative in the process.
- A loan doesn't have to be in default to be classified.
- Generally, if payment is more than 90 days late, a loan should be classified, but there are exceptions if the loan is secured by sufficient collateral.
- Classified loans have three possible designations: substandard, doubtful, and loss.