What is a Non-Performing Asset?
A non-performing asset (NPA) is a classification used by financial institutions for loans and advances that have a principal which is past due and on which no interest payments have been made. In general, loans become NPAs when they are outstanding for 90 days, though some lenders follow a shorter window before considering a loan or advance past due.
Sub-Classifications for Non-Performing Assets (NPAs)
Banks need to establish sub-classifications for non-performing assets. The four additional categories they typically use include:
1. Standard Assets
They are NPAs that have been past due for anywhere from 90 days to 12 months, with a normal risk level.
2. Sub-Standard Assets
They are NPAs that have been past due for more than 12 months. They have a significantly higher risk level, combined with a borrower that has less than ideal credit. Banks usually assign a haircut (reduction in market value) to such NPAs because they are less certain that the borrower will repay the full amount.
3. Doubtful Debts
Non-performing assets in the doubtful debts category have been past due for at least 18 months. Banks generally have serious doubts that the borrower will ever repay the full advance. This class of NPA affects the way the bank looks and how liquid it is.
4. Loss Assets
They are non-performing assets with an extended period of non-payment. With this class, banks are forced to accept that the loan will never be repaid, and they will be forced to take a loss, which must be reported on their balance sheet. The entire amount of the loan must be written off completely.
How NPAs Work
Loans, as addressed above, aren’t switched into the NPA category until a considerable period of non-payment has passed. Lenders consider all of the factors that may make a borrower late on making interest and principal payments and extend a grace period. After a month or so, banks typically consider a loan overdue. It isn’t until the end of the grace period (typically starting at 90 days of non-payment) that the loan then becomes a non-performing asset.
Banks will attempt to collect the outstanding debt by foreclosing on whatever property or asset is being used to secure a loan. For example, if an individual takes out a second mortgage and that loan becomes an NPA, the bank will generally send notice of foreclosure on the home because it is being used as collateral for the loan.
Significance of NPAs
The more debt any entity holds, the weaker it is financially and the slower its revenue stream is. It also, as mentioned above, affects how liquid the entity is. For banks and other lenders, non-performing assets can be manageable, but it depends on how many there are and how past due the loans are. In the short term, most banks can weather a fair amount of NPAs. However, if the number of NPAs continues to build over a period of time, it threatens the financial health and future success of the lender.
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