Types of Bad Loans and Their Impact on the Lender and the Borrower

Last updated on March 31st, 2024 at 09:07 pm

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If you have taken a loan from a financial institution and are unable to repay or fail to fulfill the repayment obligations due to circumstances beyond your control, that constitutes a bad loan.

Definition

Also referred to as bad debts, bad loans arise when the borrower no longer pays loans they obtained from a bank or when you fail to abide by payment terms of loans. Some people prefer to call it Non-Performing Loan (NPL).

In a country where loan sharks are rampant, you might be exposed to many loans, this may lead to a high debt-to-credit ratio.

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Some of the examples of bad debts include credit cards with high interest rates, loan sharks that promise to grant your loan application without collateral, but with ridiculously high interests such as 35% or 40% interest or more in a month.

Payday loans are another example of bad debts because they promise applicants fast cash and allow you to pay on your next payday, but you end up paying a high-interest rate.

As for credit cards, if you don’t exercise financial discipline, managing your debts might get out of control and you would be trapped.

Types of Bad Debts

Car loans

Car loans or auto financing may result in bad loans, particularly when the vehicle is used for commercial purposes and encounters damage from poor road conditions or accidents before you complete the repayment.

Vehicles depreciate in value due to a number of factors such as warranty length, road conditions, mileage, service history, and fuel economy.

Car loans come with high interest rates, especially if you have a low credit score. It may not be worth taking a car loan if you don’t have a stable source of income.

Loan sharks

Loan sharks are among the worst forms of loans that can permanently drag you into debt trap, especially if you rely on them whenever you need quick cash.

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They make it very easy to access by claiming that it takes less than a few seconds and doesn’t involve complicated documentation, which is true, but they are dangerous loans.

Their tactics involve preying on the vulnerable and luring them with seemingly friendly interest rates, which are not financially advisable when calculated beforehand.

They charge extremely high interest rates and may resort to desperate means to recover their loans, especially if you fail to fulfill repayment obligations on the due date.

In Africa, loan sharks are notorious for intimidating their clients, often resorting to cursing and name-calling if repayments are not made on the due date.

They indiscriminately circulate the debt profiles of their borrowers to third parties. While loan sharks may offer quick cash to meet immediate financial needs, dealing with them can worsen your situation and make it difficult to escape their debt trap.

Borrowers sometimes find themselves taking out additional loans from another lender to repay existing ones, resulting in accumulating interest rates and ultimately leading to bad debts.

High-interest credit card

If you’ve obtained a credit card with a high interest rate, it may be difficult for you to repay by the due date. Continuous defaults will significantly impact your credit score. You need to manage your credit cards carefully to avoid falling into bad debts. Besides, credit cards are used for purchases that do not increase your net worth, so use them cautiously.

Payday loans

Payday loans are designed for individuals who have a guaranteed source of income for daily wage earners or monthly salary earners. It may be tempting for you, especially when you’re desperate for quick cash.

It doesn’t require any form of collateral and it is more accessible than the traditional loan. You should explore other options such as talking to a friend or family member first, it should be your last resort because they come with a very high interest rate.

The interest rate on payday loans vary from country to country. In the United States, the interest rate is between 15% to 20% or even more, depending on the lender.

In the United Kingdom, the interest rates and fees are capped at 0.8% per day, which is 24% in 30 days. You could be paying £24 in 30 days on £100.

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They are one of the most expensive forms of financing in Canada.

In Nigeria, the interest rates on payday loans depend on the lender. It is 2% in Fidelity Bank and could be up to 10% in Access Bank. It is important to pay attention to other charges and the terms.

If you don’t put yourself in check, you may find yourself left with nothing by the time your wage or salary comes in. That’s why some banks have a cap on the amount you can access for payday loans. Most of the banks will approve anything beyond 50% your basic salary.

When Does a Bank Declare Loan Non-Performing?

When a borrower continuously fails to repay the loan, interest, or monthly principal, it is classified as a Non-Performing Loan (NPL). The timeframe for this classification varies from bank to bank.

NPLs are labeled as such because the likelihood of lenders recovering their loans from such borrowers is very low, especially when the borrower fails to make repayments for 90 consecutive days.

Despite being considered a bad loan, borrowers can resume repayment when they regain financial stability. When repayment resumes, the loan status can be changed to a reperforming loan.

Impacts of bad debts

on the lender

Despite the benefits that banks derive from lending and earning interest from loans, repayment can sometimes become an issue. When numerous bad loans accumulate, the lender may be at risk. Here are some of the impacts this can have on the bank:

It will affect the lender’s cash flow, potentially leading to financial problems for the financial institution. If not promptly addressed, the bank may face bankruptcy.

Banks may face a financial crisis when burdened with numerous bad debts. This difficulty can hinder their ability to offer new loans, thereby affecting their income.

The impact on the investment ratio is significant. Financial institutions and lenders attract investors, who invariably scrutinize the profit history of the company before committing to any deals. Consequently, bad loans can tarnish the reputation of the bank or lender.

Bad loans can also affect the credit risk of the lender, as they are obligated to report to financial regulatory authorities such as the country’s apex bank. A bank with a high ratio of non-performing assets is typically considered risky.

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on the borrower:

Loss of assets: If a borrower fails to repay a loan obtained from a traditional bank, the bank may seize and sell their assets. Traditional banks seldom grant loans without collateral.

Bad reporting to Credit Bureau: A borrower is classified as a bad debtor when a lender is compelled to report such an individual to the credit bureau. This action adversely affects your credit score and could impede your ability to secure a new loan.

Activation of Automatic Debit: In certain jurisdictions, the central bank provides guidelines on the modalities of loan recovery. However, before lenders resort to this method, they are required to furnish borrowers with notices of outstanding obligations. Subsequently, your bank account may be subject to automatic debit, wherein the lender deducts their loans whenever your account is credited.

Ways to avoid bad debt

Build savings funds: Prepare for rainy days by building an emergency fund in case you lose your primary source of income. Have a backup financial plan should things go south. Your emergency fund will prevent you from resorting to loan sharks

Borrowing should be your last resort: Don’t make borrowing your only option. Talk to family members or friends who can lend you some amount in times of emergencies.

Have a side-hustle: A side-hustle like freelancing is one of the ways to build multiple sources of income so that when one source fails, the other will be your backup.

Avoid deliberate default: Repay your loan whenever you are financially stable; don’t assume that the lenders have forgotten, as they never will since they maintain records of defaulters. Your name could be added to the list of bad debtors in the credit bureau database, which will continue to affect your reputation if you fail to repay.

Author

  • Opeyemi Quadri

    Ope is a finance writer and researcher with 10+ years of experience in content creation. His interests cut across decentralized finance, investment, foreign exchange, government policies and politics.

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