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Non-Performing Loan (NPL)

Non-Performing Loan (NPL)

A non-performing loan (NPL) is a significant term in the finance sector, referring to a loan where the borrower fails to honour the payments. This situation usually occurs when payments have been missed for an extended period of time.

In simpler words, it involves a borrower borrowing money and then failing to pay it back as promised. This affects both the lender and the borrower significantly.

An NPL affects the lender’s financial health and can have ripple effects on the broader economy. Understanding what an NPL is and its impact is crucial for anyone looking to apply for a loan and even financial institutions offering loans to borrowers.

This article highlights everything about an NPL loan, from a non-performing loan’s meaning and types to its examples, so that you have the complete picture when applying for a loan.

How a Non-Performing Loan (NPL) Works

Let’s first understand what is NPL? A non-performing loan refers to a loan that is in default or close to being in default. Situations like bankruptcy filing or restructuring can result in a loan being classified as non-performing. In India, the Reserve Bank of India (RBI) classifies a loan as an NPL if the interest and/or instalment of the principal remains overdue for more than 90 days.

Once a loan becomes an NPL loan, the chances of recovering the full amount from the borrower are low. It denotes that the borrower is facing financial difficulties and is unable to meet the loan obligations. For lenders, it leads to lower profits and higher provisioning costs while also restricting their ability to sanction loans.

What are the Types of Non-Performing Loans?

There are two types of non performing loans-

  1. Secured loans: These are loans that are backed by collateral such as a house, car, or other assets. In case the borrower has defaulted on the loan repayment, the lender can seize and sell the provided collateral to recover some or all of the outstanding loan balance. Common examples are mortgages.
  1. Unsecured loans: These loans do not have any collateral backing them. This means the borrower does not provide the lender with any valuable assets that can be sold to recover the loan amount. Common examples are credit cards, personal loans, etc.

What are the Examples of NPL loans?

Here is a non-performing loan example: A small auto component maker company availed a Rs 60 lakh term loan and Rs 40 lakh working capital facilities from a leading lender for business expansion.

However, the auto sector underwent a downturn, leading to reduced sales.

Due to falling sales, the company started defaulting on its loan repayment instalments after 2 months. The company had high inventory levels and could not collect receivables on time due to the slowdown. After 90 days of non-payment of interest and principal, the lender declared the company’s loans worth Rs 100 lakhs as non-performing assets.

The lender initiated restructuring discussions with the company. It also increased monitoring of the account and stopped additional disbursals under the working capital facilities. With pressure on its cash flows, the company found it difficult to turn around the account quickly. The lender had to make higher loan loss provisions due to the NPL status of the company’s loans.

Causes of Non-Performing Loans

As you now understand NPL meaning, let’s look at some factors that lead to nonperforming loans:

  • Rising interest rates – Higher loan costs from increased interest rates can make it difficult for borrowers to manage repayments.
  • Unexpected life events – Personal financial struggles, such as medical emergencies or the loss of a breadwinner, can cause defaults on personal loans.
  • Economic decline – Recessions and economic slowdowns often lead to job losses and reduced incomes, affecting a borrower’s ability to repay.
  • Business struggles – Poor management, market changes, or competition can prevent businesses from repaying loans.
  • Weak loan underwriting – If banks do not assess a borrower’s repayment ability thoroughly, the risk of nonperforming loans increases.

Impact of NPL on Banks

Here’s how NPL can impact financial institutions:

  1. Reputation damage – High levels of NPLs can harm a lender’s reputation, leading to a loss of customer and investor confidence.
  1. Profitability decline – NPLs do not generate income, which lowers the bank’s profitability, especially when a large part of the loan portfolio becomes nonperforming.
  1. Increased provisioning – Banks must set aside money to cover potential losses from NPLs, which limits the funds available for lending and other profitable activities.
  1. Capital erosion – A large number of NPLs erodes the bank’s capital, which is necessary for absorbing losses and maintaining stability.
  1. Regulatory consequences – Regulators may impose penalties or restrictions on banks with high NPLs, further affecting their operations.

How Does a Financial Institution Handle Non-Performing Loans?

When loans become non-performing, the lender takes steps to recover the amounts due and minimise losses. Here are some common methods used by lenders to handle NPL loans:

  1. Asset seizure: For loans secured by assets like property, vehicles, etc., lenders may repossess the collateral to recover money if the borrower defaults. The asset is sold, and proceeds are used to reduce the outstanding loan amount. However, the low liquidation value of seized assets often results in losses for the lender.
  2. Debt collection: Lenders engage recovery agents to follow up with borrowers for repayment of NPL loans. However, collection costs tend to be high, and recovery rates are low as borrowers usually lack funds.
  3. Loan restructuring: Lenders try to restructure loans by providing concessions to borrowers, like lower interest rates, longer repayment periods, partial write-offs, etc. This can help reduce the burden on borrowers and facilitate an easier repayment plan.
  4. Legal proceedings: Filing recovery suits in courts like the debt recovery tribunal is an option for lenders. However, the legal process tends to be long, expensive and uncertain in outcome. Hence, this step is usually taken if all else fails.
  5. Purchasing non-performing loans: Instead of directly managing non-performing loans, some lenders opt to sell these assets to other entities like asset reconstruction companies, private equity firms, etc.

Conclusion

NPL loans affect both lenders and borrowers, as seen above. As a borrower applying for a loan, make sure to research and compare financial institutions to choose one that offers interest rates, loan tenures and, most importantly, terms and conditions that are most favourable to your financial plan.

Choose a trusted financial institution like Tata Capital. Our personal loans are tailored to meet all

your financial needs. We provide competitive personal loan interest rates, flexible repayment tenures and quick approvals so you can get access to the right funds at the right time.

The details mentioned in this blog may change from time to time and from vendor to vendor or government policies.

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FAQs

Why do banks sell non-performing loans?

Banks sell non-performing loans to reduce their risk. By offloading these loans, they can focus on more profitable accounts instead of trying to recover from a defaulted loan.

Who buys non-performing loans?

Non-performing loans are often purchased by other banks, distressed debt investors, or real estate investors, who look to recover some value or restructure the loan in their favor.

How do you solve a non-performing loan?

To solve a non-performing loan, borrowers can work out a repayment plan with the lender. If you're unsure what is a non-performing loan, it refers to a loan where payments are overdue, and the borrower fails to meet obligations.