What Is a Classified Loan?

A classified loan is a bank loan that is in danger of default. Classified loans have unpaid interest and principal outstanding, but don't necessarily need to be past due. As such, 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.

Key Takeaways

  • A classified loan is a bank loan that is in danger of default.
  • Loans don't have to be past due in order to be considered classified.
  • Lenders normally record classified loans as adversely classified assets on their books as a precaution to prevent further risk and loss.
  • Lenders generally do a credit analysis to determine a borrower's creditworthiness and the quality of a loan.

How Classified Loans Work

Classified loans are any loans deemed by the lender to be in danger of default of both principal and interest. Even though they may be risky, classified loans aren't always in arrears—they're just in danger of default. This means they don't have to be past due.

As noted above, financial institutions normally record these loans on their books as adversely classified assets. These assets are flawed because repayment is questionable due to the creditworthiness of the borrowers. Banks normally classify these loans as such as a precaution in case they need to write them off as a loss. This also helps lenders cut down on any further risk.

There are several reasons why lenders may list loans as classified assets:

  • A lender that takes over another financial institution's portfolio may have more restrictive lending standards. As such, it may deem certain loans as being classified.
  • A significant drop in a borrower's credit score. Although the lender may not close the account, they may choose to monitor it more closely.
  • If the economy experiences uncertainty, it may lead to changes in employment and consumers' incomes. So when unemployment rises and incomes drop, lenders may be more likely to categorize certain loans as classified.

In some cases when a loan is considered classified, lenders may not issue any more credit to those borrowers or may tighten their lending practices altogether. Lenders may also be more inclined to increase attempts to collect on debts when borrowers default by sending out collection letters or making calls.

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

Special Considerations

Many banks undertake a credit analysis to determine the creditworthiness of a borrower and thus the quality of a loan. A credit analysis focuses on the ability of an entity—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 the ability of a borrower to repay long-term debts. A credit analyst may use the following specific liquidity ratios to determine short-term vitality:

Solvency ratios may entail the interest coverage ratio.

Aside from the possibility of having future credit restricted, borrowers with classified loans really have nothing to worry about. Having a loan marked by the lender as classified does not have a direct impact on a borrower's credit history. This means a classified loan won't show up as such on your credit file. The only time it will impact your credit score is if you default and fail to repay your loan.