How lenders manage non-performing loans
Lenders can manage non-performing loans in different ways, depending on the situation. They can take possession of the loan collateral, restructure the debt, enforce a third-party guarantee, or sell the loan at a discount.
- Take possession of collateral: If the loan is a mortgage, for example, the lender can seize the home and sell it to pay down the debt.
- Restructure the debt: The lender may reduce the interest rate, write off some principal, or lengthen the loan term to make the payments more manageable for the borrower.
- Enforce a third-party guarantee: A guarantee is an agreement by a guarantor to repay debt if the borrower defaults. The guarantor is contractually obligated for the balance of the non-performing loan.
- Sell the loan at a discount: The lender can sell the debt to a collection agency that will pursue repayment.
The right strategy is the one that minimizes losses for the lender. Note that a loan can transition from non-performing to re-performing if the borrower begins making payments again.
NPL ratio for evaluating non-performing loans
The NPL ratio is the metric commonly used to evaluate a lender's non-performing loan balance.
To calculate the NPL ratio, divide the non-performing loan balance by the lender's total loan portfolio. For example, a bank with $100 million in outstanding loans and $1 million in non-performing status has an NPL ratio of 1%.
A lender's NPL ratio is influenced by macroeconomic factors as well as the lender's underwriting policies. NPL ratios rise with higher inflation, rising unemployment, and slowing economic growth. This is why peer and historical comparisons of the NPL ratio are necessary. An NPL ratio of 1% can look poor or great -- depending on the economy.
For context, the NPL ratio of the entire U.S. in 2022 was 0.7%, according to the World Bank. But in 2009, in the wake of the financial crisis, the nationwide NPL ratio was 5%.
If a lender's NPL ratio is much higher than the current norm, that's likely related to underwriting issues. High-risk lending can cause a lender's NPL ratio to rise over time when economic conditions are positive. Risky lending practices are also associated with bank failures, including the 2023 shutdown of Silicon Valley Bank.
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