What Is a Nonaccrual Loan?
A nonaccrual loan is a nonperforming loan that is not generating its stated interest rate because of nonpayment from the borrower. Nonaccrual loans are more likely to default, meaning that the lender will not receive its principal and interest unless the borrower has adequate collateral to cover the loan. Because these loans can have interest credited only when the borrower makes a payment, the interest on a nonaccrual loan is recorded as earned income. Nonaccrual loans are also sometimes referred to or described as a 'doubtful' loan, a 'troubled' loan or a 'sour' loan.
How a Nonaccrual Loan Works
A nonaccrual loan happens after 90 days of nonpayment, and interest stops accumulating. The bank classifies the loan as substandard and reports the change to the credit reporting agencies, which lowers the borrower's credit score. The lender changes its allowance for the potential loan loss, sets aside a reserve to protect the bank's financial interests, and may take legal action against the borrower. The loan is put on a cash basis, meaning that interest is only recorded as earned when payment is collected, not as an assumed payment. Ordinarily, interest income is accrued on loans, since regular payment of both principal and interest is assumed.
According to the Federal Deposit Insurance Corp. (FDIC), an asset is to be reported as being in nonaccrual status if one of three criteria are met:
- It is maintained on a cash basis because of deterioration in the financial condition of the borrower;
- Payment in full of principal or interest is not expected, or;
- Principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection.
A well-secured asset is one that is secured by collateral (liens, pledges of real or personal property or securities valuable enough to cover the debt, or is guaranteed by a financially responsible party.
Unless a loan has adequate collateral (such as with a mortgage) if interest is not paid for 90 days the loan is put on a cash basis, meaning any interest cannot be credited to the lender’s revenue account until it has been received.
Restructuring a Nonaccrual Loan
After entering nonaccrual status, the borrower typically works with the lender in determining a plan for paying off the debt. After reviewing the borrower's income and expense status, the lender may create a troubled debt restructure (TDR).
The TDR may erase part of the loan's principal or interest payments, lower the interest rate, allow interest-only payments, or modify repayment terms in other ways. Lower debt payments may be made until the borrower's monetary circumstances improve. The lender may recoup at least its principal, rather than losing its entire investment.
Returning a Loan to Accrual Status
One option for returning a loan to accrual status involves the borrower paying all overdue principal, interest, and fees and resuming monthly payments as outlined in the contract. Another option involves keeping current with scheduled principal and interest payments for six months and providing the lender reasonable reassurance that the outstanding principal, interest, and fees will be paid within a set amount of time. A third option requires that the borrower provide collateral for securing the loan to the lender, repaying the outstanding balance within 30 to 90 days, and resuming monthly payments as detailed in the contract.
Example of a Nonaccrual Loan
In the fourth quarter of 2017, a $91.5 million loan from Bank A to Company B was on nonaccrual status. When Bank A assumed the loan, the bank already had $60 million at cost and $49 million at fair market value (FMV) in loans to Company B. Taking on the additional debt, the loan was converted to preferred and non-income producing. None of the investments appeared to be paying current income. Bank A believes Company B will turn around and the debt will be repaid.