What is a Classified Loan?

A classified loan is any bank loan that is in danger of default. Classified loans have unpaid interest and principal outstanding, and it is unclear whether the bank will be able to recoup the loan proceeds from the borrower. Banks usually categorize such loans as adversely classified assets on their books.

Classified loans have failed to meet acceptable credit standards, according to bank examiners. The credit quality has essentially declined since initial approval. This type of loan has a high rate of borrower default and can raise the cost of borrowing money for the bank's other customers.

[Important: Classified loans have a high rate of borrower default and can raise the cost of borrowing for a bank's other customers.]

The Whys and Hows of Credit Analysis

To determine the creditworthiness of a borrower and thus the quality of a loan, many banks will undertake a credit analysis. A credit analysis focuses on the ability of an entity, such as an individual or a company, to meet its debt obligations. Lenders will generally work through the five C's to determine credit risk, looking into an applicant's:

  1. Credit history
  2. Capacity to repay
  3. Capital
  4. Conditions and terms of the loan
  5. Collateral (In a mortgage transaction, for example, collateral is the house, which the party purchases with the funds from the mortgage. If payments on this debt cease, the lender can take possession of the house through a process called foreclosure.)

Credit analysis is a form of due diligence, which often relies on liquidity and solvency ratios. Liquidity measures the ease with which an individual or company can meet its financial obligations with the current assets available to them, while solvency measures ability to repay long-term debts. A credit analyst may use the following specific liquidity ratios to determine short-term vitality: current ratio, quick ratio or acid test, and cash ratio. Solvency ratios might entail the interest coverage ratio.

Classified Loans and High-Yield Bonds

A classified loan and a high-yield bond are similar in that both may have reduced credit ratings. High-yield bonds are also called junk bonds in contrast with investment-grade corporate bonds, Treasury bonds and municipal bonds. Given classified loans’ higher risk of default, they often pay a higher yield than investment grade bonds. Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios.

A bond yield is the amount of return an investor realizes on a bond. Several types of bond yields exist, including nominal yield, which is the interest paid divided by the face value of the bond, and current yield, which equals annual earnings of the bond divided by its current market price.