Definition of a Problem Loan

A loan that includes payments that are more than a few months past due is considered to be a problem debt. There are some subtle distinctions between issue consumer loans and problem business loans. Consumer debts are in poor standing if they are more than 180 days beyond the due date. On the other hand, this time period is shortened to ninety days for commercial loans.

Take a look at the following example: Consider the following scenario: to purchase equipment for your company, you have received a commercial loan for $50,000. You are responsible for making a monthly payment of $500, due on the 15th of each month. Your company has been operating at a loss for the last three months, and it has been two years since you opened its doors. Because you have not made any payment installments for this loan in more than ninety days, the lender has classified it as a problem loan.

What is the Procedure for a Problem Loan?

There is no universally accepted definition of what constitutes a bad loan. If payments on a loan are more than ninety days late in the United States, the debt is considered a "problem" state. For consumer loans, this period might be extended to 180 days. The problem loan ratio of a bank is the proportion of its problematic loans to its total assets; it is expressed as a ratio. The banks keep the ratio as low as possible by making it a priority. The higher the ratio, the more likely the bank will incur a big loss if the defaulted payments are not recouped.

Banks may be responsible for the high number of problematic loans they hold. Even though it is the borrower's responsibility to adhere to the conditions mentioned in the loan agreement, banks with questionable lending practices may provide funding to applicants who do not meet the requirements. People who do not possess the capacity and resources necessary to repay debt are likely to fail on their payments for the loan. The following are some examples of improper lending policies:

• When the borrower does not have adequate owner equity in the property, accepting real estate as security
• Accepting collateral with an uncertain value in the event of liquidation
• Accepting applications from borrowers with dubious reputations and poor credit
• The failure to gather financial statements to conduct an accurate assessment of the creditworthiness of a borrower
• Insufficient oversight to monitor the implementation of responsible lending policies
• The failure to properly examine how changes in economic circumstances might impact the borrower's ability to make payments

What It Implies for Those Who Invest on Their Own

It is possible to determine the quality of a bank's stock by comparing the volume of that bank's problem loans to the overall assets of that bank; if the ratio is low, this shows that the bank has effective risk management. When the economy or a particular sector is experiencing a downturn, investors might look to a bank's problem loan ratio as a reflection of its overall financial health. Comparing a bank's problem loan ratio to the average for the industry may assist investors in evaluating not just the performance of a bank but also the quality of its stock.

Notable Happenings

From 2007 to 2009, while the economy was amid the Great Recession, the lending sector was a tremendous hit. The rates of delinquency and loss at banks were found to have grown. To better handle problematic debts, certain financial institutions stopped all lending activity.

Banks have tightened their underwriting criteria to compensate for their losses and decrease the risk of future losses. These new standards include better credit ratings and a robust cash flow on commercial loans. Some financial institutions were cautious about securing loans using real estate as collateral as a result of the large declines in asset prices.

Mortgage loans and other real estate financing were similarly difficult for agricultural borrowers. Because of the steep drop in housing values, many borrowers are now in a position where they are unable to repay their mortgage payments. Farmers' income dropped by 25% in 2009, contributing to the rise in the percentage of problem farmer real estate loans from 0.75 percent in 2006 to 2.9 percent in 2011.

Special Considerations

Many businesses see the purchase of troubled assets and debts that are not functioning well as a lucrative opportunities. A substantial business opportunity might be found in purchasing these debts from financial institutions at a discount. Companies often make payments ranging from 1% to 80% of the remaining debt on their loans, at which point they become the loan's legal owner.