What Is Default?
Individuals, societies and business entities often take loans from banks and financial institutions, which have to be repaid over a period of time, with interest and/or other financial fees and charges. A Default is basically the failure to pay back the debt, including the interest or principal amount on this debt or loan or mortgage or security. When the borrower can’t make timely payments or misses an instalment or two or even stops making payments, it is said to be defaulting on the loan.
Default risks are usually calculated by lenders before they give out loans, so as to secure themselves from bad debts and non-performing assets.
What is Non Performing Assets (NPA)?
Sometimes, lenders or banks give out loans and advances which haven’t been paid or have been overdue for quite a while. ‘Non Performing Assets’ or otherwise known as NPA is when the principal or interest payable to a lender has been overdue for a period of 90 days (3 months) or more.
Banks are asked to classify non-performing assets further into 3 types, namely substandard assets, doubtful assets and loss assets, depending on the period of time that they have remained non-performing. See more:
- Substandard Assets: Here, the asset has remained an NPA for a period equal to or less than 12 months.
- Doubtful Assets: Here, the asset has remained a substandard asset for a period of 12 months.
- Loss Assets: As per the Reserve Bank of India (RBI), a loss asset is one where the asset is considered non-collectible or of extremely low value. Sometimes, there may a little salvage value but continuing this as a bank asset is no longer justified.
What Is a Loan?
In financial terms, a loan is a sum of money borrowed or lent for a period of time, in exchange for the repayment of the same sum of money along with additional interest and/or other financial charges. Banks and financial institutions loan out homes, properties, money and other commodities to individuals and business houses and earn from the interest being paid back on the principal amount or value of the loan.
Loans are assets for the banks and lenders as they continuously earn them money in the form of interest. However, sometimes loans remain unpaid or overdue and when they are overdue for a period of 90 days and more, they are said to be non-performing assets (NPAs) for the banks, as the chances of repayment from the borrower reduce.
Types of Non Performing Assets (NPA)
A non-performing asset (NPA) is when the interest or principal on a loan or mortgage or other asset remains unpaid for a period of 90 days, for whatever reason. NPAs are not good for the business of banks and other financial institutions as they cut into their profits. There are 3 types of NPAs, mentioned below:
- Substandard assets: NPAs are divided on the basis of the period for which the loan is unpaid. When the interest on a loan has gone unpaid for a period of 12 months, the asset is said to be a substandard asset.
- Doubtful assets: When an asset has remained a substandard asset for a further period of 12 months, it is known as a doubtful asset literally because of the doubt of being paid back.
- Loss assets: When the bank declares an asset to be of extremely low value or almost not collectible, it is called a loss asset. The amount that can be salvaged from this asset is almost negligible and it’s no longer worth being considered an asset.
What is Doubtful assets
Banks, lenders and other financial institutions give out loans and advances to those in need. When the interest payable on these loans and advances are overdue for over 90 days, they go into the category of being a ‘Non-Performing Asset’. Also called an NPA, these assets are further divided into substandard assets, doubtful assets and loss assets, depending on the time that they’ve remained overdue.
If the asset is an NPA for up to 12 months, they are substandard assets while the minute it crosses the 12-month mark, it is categorized by the banks as a Doubtful Asset. Quite literally speaking, the chances of salvaging the amount unpaid are doubtful, hence the name doubtful assets.
What is Substandard assets?
Banks and financial institutions often give out loans and advances to people and companies in need. Sometimes, these loans are unpaid or overdue for a very long time. When the interest payable is overdue for 90 days, the asset is termed as a ‘Non-Performing Asset’ or NPA. NPAs are of three types namely substandard assets, doubtful assets and loss assets.
Talking about substandard assets, these are those assets which have remained in the NPA category for less than or equal to 12 months. These are non-performing assets but there are still chances of recovery or salvage. When the asset remains an NPA for more than 12 months (1 year), it then gets termed as a doubtful asset.
What Is the Principal?
The word ‘Principal’ has several financial meanings. Most commonly, principal is the sum of money due in a loan, before interest any other financial charges. Similarly, it’s the main amount invested before any returns gained. Every loan taken starts as principal. Following then, for every period that the principal remains unpaid in full, the loan will start attracting interest and other fees.
It works in the same way for an investment. Except instead of paying over and above the principal in the form of interest, the investor is earning on his principal.
What is ‘Nim’
‘NIM’ is an important part of banking jargon thanks to it’s frequent use in financial institutions. Literally speaking, NIM means ‘Net Interest Margin’, which basically means the difference between the sum of interest income earned and the total interest paid out by a bank or any other financial institution, in relation to its income-earning assets.
Simply put, the NIM measures the investment decisions of a bank or financial institution. A higher NIM number increases the profitability of a lender while a dropping NIM means that the institution isn’t being able to make right use of it’s interest earning assets.
NIM = (investment returns – interest expenses) / average earning from assets
Let’s look at a simple example. Say ‘XYZ’ bank has interest earnings of Rs. 10,000 and they paid out Rs. 8,000 on their cash deposits, with their average loan assets being Rs. 85,000. The NIM for the year will be (10,000 – 8,000) / 85,000 = 0.02352 or just 2.35%. In this example, the NIM for the year for XYZ bank is 2.35%.
In the case of rising number of non-performing assets (NPA), the interest being earned by a bank would fall which would lead to a decline in NIM as well. The Net Interest Margin is an important indicator of the financial stability of a lending bank. In India, all of the top banks report a NIM between 3-4.5%. However, do not confuse NIM for profitability of the institution as it doesn’t take into consideration certain other factors like non-interest incomes and other fees being charged.