Banks depend on borrowers to maintain their scheduled loan repayments as a major source of revenue. When a borrower has not made regular payments for at least 90 days, the loan is considered a nonperforming loan, or NPL. The nonperforming loan ratio, better known as the NPL ratio, is the ratio of the amount of nonperforming loans in a bank's loan portfolio to the total amount of outstanding loans the bank holds. The NPL ratio measures the effectiveness of a bank in receiving repayments on its loans.
When Loans Become Nonperforming Loans
The odds of loan repayment decrease significantly after 90 days, which is why the nonperforming loan designation uses this standard. Loans can be classified as nonperforming if the borrower defaults on the loan, declares bankruptcy or loses the income she needs to repay the debt. Because nonperforming loans can hurt a bank's standing as a borrower, the bank may choose to sell these loans to collection agencies or other businesses to recover its losses.
Total NPL Calculation
The total amount of the loan, not just the outstanding loan balance when the loan was considered nonperforming, counts toward the NPL total. For instance, if a borrower had a $100,000 loan, repaid $40,000 on time, but went 90 days behind on his payments with $60,000 still due, the entire $100,000 would be classified as a nonperforming loan. If the borrower starts repaying the loan again after it has been classified as nonperforming, that loan is removed from the NPL total. If the bank sells the loan to another agency for collection, that loan is also removed from the NPL total.
NPL Ratio Calculation
The calculation method for the NPL ratio is simple: Divide the NPL total by the total amount of outstanding loans in the bank's portfolio. The ratio can also be expressed as a percentage of the bank's nonperforming loans. For instance, say Alpha Bank has a total loan portfolio of $200 million, with $5 million in nonperforming loans. Alpha Bank's NPL ratio is ($5,000,000/$200,000,000) = (5/200) = 0.025, or 2.5 percent.
Uses for NPL Ratio
Financial analysts frequently use the NPL ratio to compare the quality of loan portfolios among banks. They may view lenders with high NPL ratios as engaging in higher-risk lending, which can lead to bank failures. Economists examine NPL ratios to predict potential instability in financial markets. Investors can view NPL ratios to choose where to invest their money; they can view banks with low NPL ratios as being lower-risk investments than those with high ratios.