Definition and Examples of a Problem Loan
A problem loan is a loan that has delinquent payments extending several months. Rasti Nikolic, a financial consultant at Loan Advisor, told The Balance in an email that there are slight differences between problem consumer loans and commercial loans. “If consumer loans are 180 days past the due date, they are considered bad loans,” she said. “However, for commercial loans, this period is reduced to 90 days.”
- Alternate name: Nonperforming loan
Consider this example: Let’s say you secured a $50,000 commercial loan to buy machinery for your business. Your monthly payment is $500, due on the 15th of each month. Two years in, your business is struggling and you’ve defaulted on three consecutive monthly payments. Since you have not made payment installments for more than 90 days, your loan is considered a problem loan.
How Does a Problem Loan Work?
The definition of a problem loan can vary by country. In the United States, loans typically reach “problem” status if payments are at least 90 days past due. This can be extended to 180 days for consumer loans.
Individuals might default on several consecutive payments for various reasons, such as unemployment, illness, injury, or a divorce. Economic recessions or a pandemic can affect a borrower’s ability to repay a loan, too.
A bank’s problem loan ratio represents the ratio of a bank’s problem loans relative to its total assets. Banks strive to keep the ratio as small as they can. Higher ratios indicate a significant loss to the bank if the defaulted payments are not recovered.
Banks can be partially responsible for the volume of problem loans they carry. While borrowers are obligated to fulfill the terms outlined in the loan agreement, banks with problematic lending policies may be extending financing to unqualified applicants. Individuals who lack the ability and resources to repay a loan will likely default on their payments.
Examples of poor lending policies include:
- Accepting real estate as collateral when the borrower has insufficient owner equity
- Accepting collateral with questionable liquidation value
- Approving borrowers with questionable character and bad credit
- Failure to collect financial statements to properly evaluate a borrower’s creditworthiness
- Lack of supervision to oversee enforcement of sound lending policies
- Failure to assess how economic conditions can affect a borrower’s repayment potential
Identifying and Managing Problem Loans
Several signs can predict a problem loan.
“Lenders first look at the number of missed payments,” Nikolic said. “A significant decline in the value of the collateral is also a sign of a problem loan. For businesses, constant drop in prices of shares, diminishing deposit balance, and unpaid loans from other institutions indicate problem loans.”
Lenders can sometimes catch a loan before it reaches “problem” status.
“If banks recognize a problem loan on time, they reach out to the borrower,” Nikolic said. “Generally, they provide the option to pay a part of the payment immediately and remaining later.”
To manage existing problem loans, some banks have work-out units. Work-out units are comprised of specialized lenders that sometimes operate independently from the lending unit. These units may work with the borrower to restructure the loan terms. In some cases, they may be forced to foreclose on underlying collateral.
Amidst the 2009 financial crisis, the Federal Reserve issued a press release supporting commercial real estate loan workouts. Many borrowers were struggling with diminished cash flow and delays in selling or renting commercial properties. The press release included resources on how lenders could work with creditworthy borrowers facing financial hardship.
What It Means for Individual Investors
The volume of a bank’s problem loans compared to its total assets can indicate the quality of that bank stock—a low ratio suggests that the bank has good risk management. Investors can look to a bank’s problem loan ratio to signal its financial health, especially during economic or industry declines. Comparing a bank’s problem loan ratio against the industry average can help investors evaluate a bank’s performance and stock quality as well.
The lending industry took a significant blow during the Great Recession from 2007 to 2009. Banks reported increased delinquency and loss rates. Some banks suspended all lending activities to manage problem loans.
To compensate for their losses and reduce future risk, banks tightened their underwriting standards, requiring higher credit scores and strong cash flow on commercial loans. Due to the significant drops in asset values, some banks were hesitant about securing loans with real estate.
Mortgage loans and real estate loans issued to farmers also faced challenges. Housing prices dipped dramatically, leaving several borrowers unable to repay their mortgage loans. Farmers’ income fell by 25% in 2009, contributing to the increase of problem farmer real estate loans from 0.75% in 2006 to 2.90% in 2011.
- A problem loan is a loan that has not been paid for more than 90 days for a commercial loan or 180 days for a consumer loan.
- Some reasons a loan might transition into a problem loan include poor lending policies or the borrower struggling with a life event, such as the loss of a job, injury, or a divorce.
- Investors can compare a bank’s problem loan ratio to other banks within the industry to evaluate the institution’s risk management process.