When banks lend out money, they do so with the hope that their borrowers will make their payments as scheduled. But that doesn't always happen. Sometimes borrowers run out of money or fall into situations where they can't repay their debt, and that's how non-performing loans become a problem for so many banks. A non-performing loan, or NPL, is one that is in or close to default. This typically happens when principal and interest payments on the loan are overdue by 90 days or more. Non-performing loans are generally considered bad debt because the chances of them getting paid back are minimal. The more non-performing loans a bank has on its books, the more its stock price is likely to be affected.
What banks do with non-performing loans
There's always technically a chance that a debtor will start making payments again on a non-performing loan, but most of the time, it doesn't happen. Banks that hold non-performing loans have the option to take steps to recover what they're owed. For loans that are backed by specified assets, banks can pursue avenues such as foreclosure for homes and repossession for vehicles. For loans that aren't backed by specified assets, banks often have a harder time recouping what they're owed.
Banks also have the option to sell non-performing loans to outside investors or collection agencies. With the latter, what typically happens is that the debt is sold at a reduced price to the agency, which then attempts to collect that debt and make money on non-performing loans that are eventually repaid. Banks can also partner with collection agencies, which often agree to pursue bad debts in exchange for a percentage of whatever amount is recouped.
How non-performing loans affect banks
A large percentage of non-performing loans can affect a bank negatively, but it can also affect outside would-be borrowers. When loans become non-performing, banks stop collecting interest on them, which is how they make money. When a bank has too many non-performing loans on its books, it doesn't just lose money, but it also has less money available for new loans, which can leave prospective borrowers with fewer options.
Banks with a large amount of non-performing loans relative to their total assets are also a less attractive stock investment than those whose books paint a more favorable picture. If a bank's percentage of non-performing loans increases, it could cause its stock price to go down. Banks that see an increase in non-performing loans should reevaluate their lending practices and take steps to better vet their borrowers to protect their own best interests and those of their stockholders.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!