Problem Loan: What it Means, How it Works

What Is a Problem Loan?

In the banking and credit markets, a problem loan is one of two things: A commercial loan that is at least 90 days past due or a consumer loan that is at least 180 days past due. In either case, this type of loan is also referred to as a nonperforming asset (loan).

How a Problem Loan Works

Any loan that cannot quickly be recovered from borrowers is called a problem loan. When these loans can't be repaid according to the terms of the initial agreement—or in an otherwise acceptable manner—a lender will recognize these debt obligations as problem loans.

A central piece of credit management is the early recognition and proactive management of distressed loans, protecting a lender from exposure to undue risks. Carrying problem loans on their balance sheets can reduce lenders' cash flow, disrupting budgets and potentially decreasing earnings. Covering such losses can reduce the capital lenders have available for subsequent loans.

Lenders will try to recoup their losses in a variety of ways. If a company is having trouble servicing its debt, a lender may restructure its loan to maintain cash flow and avoid classifying it as a problem loan. On a defaulted loan, a lender might sell any collateralized assets of the borrower to cover its losses. Banks can also sell problem loans that are not secured by collateral or when it isn't cost-effective to recover the losses.

Special Considerations

Many companies see a business opportunity in acquiring problems and nonperforming loans. Buying these loans from financial institutions at a discount can be a lucrative business. Companies regularly pay from 1% to 80% of the total loan balance and become the legal owner (the creditor). This discount depends on the age of the loan, whether an asset is secured or unsecured, the debtor's age, personal or commercial debt classification, and place of residency.

The subprime mortgage meltdown and the 2007-2009 recession led to a rise in the number of problem loans that banks had on their books. Several federal programs were enacted to help consumers deal with their delinquent debt, most of which focused on mortgages.

These problem loans often resulted in property foreclosure, repossession, or other adverse legal actions. Many credit investors willing to ride out the mortgage mess are happy today, as they sometimes could acquire assets for pennies on the dollar.