What Is a Cash Basis Loan?
A cash basis loan is one in which interest is recorded as earned when payment is collected. Ordinarily, interest income is accrued on loans, as regular payment of both principal and interest is assumed. However, in the case of nonperforming loans (or loans gone bad), continuing payments are doubtful. Cash basis loans are nonperforming loans, and interest income can only be recorded when funds are actually received.
Typically, loans are considered to have gone bad when they are in default for 90 days, meaning that the borrower hasn’t made any scheduled principal or interest repayments for at least that period. Different definitions may apply to consumer loans, residential mortgage loans, and other secured assets.
How a Cash Basis Loan Works
Loans often go into default because the borrower has fallen on hard times or run out of money and can’t continue to make payments. Banks usually consider cash basis loans bad debt because it’s unlikely that they’ll be able to collect on them. For this reason, nonperforming loans can present a big problem for a bank. When a bank has many cash basis loans on its records, its stock price can suffer. Nonperforming loans can cause a bank to lose money, and they can mean that a bank has less money available to lend to other customers.
In theory, it remains possible that a debtor may once again start making payments on a nonperforming loan, but in practice this rarely happens, and banks must figure out another way to collect on the loan. How a bank approaches collecting on a cash basis loan will depend on whether or not the loan is secured. If a nonperforming loan is secured by an asset, such as a car or home, the bank may attempt to recover some of its losses by foreclosing on or repossessing the asset in question.
Another option banks have for dealing with cash basis loans is to sell them to collection agencies or investors. This is usually done with cash basis loans that are not secured by an asset that can be repossessed or foreclosed. The bank can sell nonperforming loans at a reduced price to a collection agency, which then becomes the owner of that debt and may attempt to collect on it, perhaps by settling with the debtor for less than the amount owed. However, a bank can also form a partnership with a collection agency that can help it pursue payment for cash basis loans in exchange for a percentage of any funds obtained thereby.
A cash basis loan is a loan gone bad, therefore one in which interest is recorded as earned only when payment is collected.