Impaired Loan
An impaired loan is one where it is probable that the creditor will be unable to collect all the scheduled payments of principal and interest. These loans typically exhibit signs of significant financial difficulty for the borrower.
Bad Loan
A bad loan, also known as a non-performing loan (NPL), is one where the loan is confirmed as non-collectible and is written off from the creditor’s balance sheet. Bad loans are essentially impaired loans that have deteriorated to the point of complete uncollectability.
Impaired Loan Assessment
To determine if a loan is impaired, financial institutions evaluate the present value of expected future cash flows, discounted at the loan’s original effective interest rate. This involves:
- Monitoring payment schedules.
- Assessing borrower’s financial health.
- Considering collateral value.
Bad Loan Criteria
A loan is classified as bad if:
- Payments are overdue for 90 days or more.
- Collection efforts are deemed futile.
- The borrower declares bankruptcy.
Present Value Calculation for Impaired Loans
$$ \text{PV} = \sum \left( \frac{CF_t}{(1+r)^t} \right) $$
Where:
- \( PV \) = Present Value
- \( CF_t \) = Cash Flow at time \( t \)
- \( r \) = Discount Rate
- \( t \) = Time Period
Financial Statements
- Impaired Loans: Must be disclosed with adjustments for expected losses, impacting the income statement and balance sheet.
- Bad Loans: Written off entirely, affecting the bank’s capital and reserve requirements.
Risk Management
Identifying impaired loans early can prevent them from becoming bad loans and mitigate financial risk.
- Non-Performing Asset (NPA): An asset that ceases to generate income for the lender.
- Loan Loss Provision: An expense set aside as an allowance for uncollected loans and loan payments.
FAQs
What happens when a loan becomes impaired?
When a loan becomes impaired, the lender reassesses the loan value and makes provisions for potential losses.
Can an impaired loan be recovered?
Yes, through restructuring or improved financial conditions, an impaired loan can return to performing status.
How is a bad loan written off?
A bad loan is written off through a charge-off process, removing it from the lender’s balance sheet and reflecting it as a loss.