What is a non-performing loan?

A non-performing loan, also known as an NPL, is a loan where the borrower has stopped paying the installments on the principal (original amount) and interest – it is effectively in default or very close. The term can be spelled ‘nonperforming loan’ without the hyphen.

Most loans become non-performing if payments are more than 90 days overdue – this will depend on the terms of the contract.

As soon as a loan is non-performing, the likelihood of it being repaid in full are considered to be significantly lower.

If payments resume on a non-performing loan, it becomes a re-performing loan, even if the borrower is still behind on payments.

Banks and other financial institutions may opt to sell their non-performing loans in order to clear their balance sheets of risky assets. They are sold to Asset Management Companies (AMCs), which try to recover as much of the money owed as possible.

AMCs use public or bank funds to remove non-performing loans from the banks’ books.

Federal Home Loan Mortgage Corporation (Freddie Mac) often sells non-performing loans. On its website, the US public government-sponsored enterprise writes:

“Subject to market conditions, Freddie Mac plans to periodically sell seriously delinquent non-performing loans (NPLs) it owns via competitive auctions. NPL sales are an important tool for the company to more effectively manage credit losses on its delinquent loan portfolio.”

Nonperforming loanToo many non-performing loans can seriously harm a bank’s prospects.

Financial institutions usually set money aside to cover potential losses on loans (loan loss provisions). They write off their bad debt in their profit and loss account.

Authorities monitor non-performing loans closely

Non-performing loans can cause serious problems for lenders. They are no longer producing income and represent money that is probably lost, thus posing cash problems for banks.

In the United States, for example, if a bank has too many non-performing loans it will be scrutinized carefully by the FDIC (Federal Deposit Insurance Corporation), an independent agency created by Congress to maintain stability and public confidence in the country’s financial system.

According to the International Monetary Fund:

“A loan is non-performing when payments of interest and principal are past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full.”

Example of a non-performing loan

Imagine XXX Bank granted a $2 million loan to YYY Inc. The arrangement was for YYY to repay in monthly installments of $50,000. The borrower promptly paid every month for two years, and then ran into serious cash flow problems because its main client went bankrupt.

It has now been three months without any payments coming in from YYY. At this point XXX has a non-performing loan. If YYY continues not paying, the odds of the bank ever getting its money back decline considerably.

A non-performing loan is a type of bad debt.

Non-performing loans to total loans ratio

Banks usually report their ratio of non-performing loans to total loans (bank non-performing loans to total gross loans) as a measure of the quality of their loans outstanding. A smaller ratio points to lower losses for the bank, while a larger ratio could mean the bank is or will be in trouble.

Bank non-performing loans to total gross loans are defined by the World Bank as:

“The value of nonperforming loans divided by the total value of the loan portfolio (including nonperforming loans before the deduction of specific loan-loss provisions). The loan amount recorded as nonperforming should be the gross value of the loan as recorded on the balance sheet, not just the amount that is overdue.”