Understanding the Difference Between Bad Loans and Good Loans for Banks

There are terms, such as “good loan” and “bad loan,” which classify lending into two types depending on their impact on the banks and the borrowers. For a bank, this difference between good and bad loans is imperative because it will determine what risk exposure the bank takes, whether the loan makes a profit, and its ability to make further loans.

This blog discusses the difference between good and bad loans, why it is important, and what that means for the banks.

What Is a Good Loan?

A good loan is, first, a serviced loan. That is, the loan is serviced according to agreed terms: the borrower repays both the principal and the interest on time; thus, the risk of loss for the bank is minimal. The banks characterize such loans as “performing assets.” This term refers to loans that yield income in the form of interest, and interest constitutes the primary revenue source of financial institutions.

Good loans are characterized by:

1. Regular Repayment: The loan borrowers maintain a regular repayment schedule.
2. Low Risk: Good loans are given to financially stable individuals or companies with minimal chances of defaulting.
3. Cash Flow Sustainability: Good loans ensure the sustainability of cash flow and liquidity of a bank.
4. Improvement in Credit Score

A good loan repayment for which the borrower is credit-abled to take further borrowing means strengthening the borrower’s credit score. Good loans are essential from the banks’ point of view in at least two ways steady income and further potential cross-selling, various services like savings banks, investment products, or general insurance, to and by responsible borrowers.

What is a Bad Loan?

Bad loans, also known as Non-Performing Assets (NPAs), are those against which scheduled payments on the principal or interest have remained overdue. Banks classify them as NPAs when, for 90 days, a loan remains unpaid. Bad loans affect the financial strength of a bank as bad loans tie up capital with irresponsible borrowers, thereby curtailing profitability.

The characteristics of bad loans are as follows:

1. Missed Payments: The borrowers of bad loans have defaulted, hence, making the loan non-performing.
2. High Risk: Bad loans are generally given to those borrowers with low credit scores or a high debt-to-income ratio.
3. Cash Flow Disruption: Bad loans affect cash flow and, hence, available capital for lending.
4. Effect on Credit Score: Defaulting on a loan adversely affects the credit score of the borrower, which makes it difficult for him to obtain further credit.

Bad loans for banks translate into a loss of revenue and increased operating costs because of the efforts taken to recover the outstanding amount. At times, the banks sell these bad loans to Asset Reconstruction Companies (ARCs) at a discount to minimize losses.

Why the Difference Matters to Banks

1. Stability: Too many bad loans can create a bank’s instability and send it to liquidity issues, and regulatory action.
2. Ability to Lend: Good loans help a bank build up capital for lending while bad loans drain the capital of the bank and force it to provision more, thus restricting lending abilities.
3. Profitability: Good loans positively contribute to profitability through interest income, whereas bad loans raise the cost of finance for a bank through lost revenue and recovery costs.
4. Credit Rating Impact: A bank with a high proportion of NPAs may experience credit rating downgrades, which implies an increase in borrowing costs and further strained resources.

Steps Banks Take to Reduce Bad Loans

Different methods are applied by banks to reduce bad loans. They perform strict credit checks before lending, monitor repayments closely, and take advanced measures such as restructuring loans to assist borrowers facing financial stress. Other banks sell or securitize loans and, in return, get rid of bad loans from their balance sheet.

Thus, It is distinct from a bad loan in that the former reflects the status of repayment, which again influences profitability, stability, and growth for a bank. The revenue streams of a bank are highly dependent on good loans because they create the avenue for expanding further credit to its customers. Bad loans would downgrade this stability, consume resources and reduce the operational capability of a bank. When the banks understand and manage this distinction, they are going to maintain healthy portfolios and support economic growth as well as protect their financial bases.