A non-performing asset (NPA) is a financial debt instrument in which the borrower has failed to make previously agreed-upon interest and principal repayments to the specified lender over an indefinite period of time. As a result, the non-performing asset does not generate any income for the creditor in the form of interest repayments. Let’s talk about and learn all about non-performing assets. What are they and how do they affect you?
What are Non-Performing Assets?
These non-performing assets are listed on a bank’s or financial organization’s balance sheets. If the non-payment continues over a drawn-out time period, the lender can force the borrowers to sell or liquidate predetermined assets to balance out the debt. If there was no agreement to collateralize assets, the bank or financial institution could write off the debt as bad debt then sell the debt to a debt collection agency at a discounted price.
Let’s look at an example to make it simpler to understand. A company borrows $5 million as a loan from a creditor. The lender agreed to make monthly payments of $50,000 to repay the loan. The borrower then fails to repay for three to four back-to-back months. The creditor then will have to categorize the loan as a non-performing asset in order to meet regulatory requirements. Also, banks may consider loans as non-performing assets even if one makes all the interest payments, but hasn’t repaid the principal amount at the time of maturity.
Usually, debts can be considered non-performing assets after a non-payment period of 90 days. Ninety days is the standard period after which the loan is classified as non-performing. These time periods can vary depending on the agreements and contracts made in the initial stages of the loan.
Three Ways to Classify a Non-Performing Asset
There are three different ways a non-performing asset can be classified depending on the length of time payment has been overdue and the probability of receiving payment. The first classification is a Substandard asset, which is when an asset has been non-performing for fewer than 12 months. The second classification is the Doubtful Assets.
Doubtful assets are those that have been non-performing for over 12 months. The third and final category is the Loss Assets. Loss Assets are those non-performing assets that one considers lost. The bank or financial institution has to write off loss assets.
Effects of Non-Performing Assets on Lender and Borrower
The effects of NPAs are felt by both the borrowers and the lenders. For borrowers, if their assets are non-performing and they aren’t making interest payments, it hurts their credit score. It can cause you not to be able to borrow in the future and also could make it harder to open new accounts. All this adds up and can hamper a person’s financial growth significantly.
For lenders, like a bank or financial institution, loans are their main source of making money, which means non-performing assets reduce their ability to generate their income. This further affects their profitability overall. A significant number of NPAs cause the lenders not to be liquid enough, further affecting their growth. Having a high number of non-performing assets on a bank’s balance sheet is an indication that the bank might be at risk of financial failure.