Definition of a Classified Loan

A classified loan is the term used for any loan that a bank examiner has deemed to be in danger of defaulting. The borrower do not necessarily need to miss payments order for a bank to label the account in this manner. A borrower can have what the bank calls a classified loan for different reasons. This is simply a precaution that financial institutions take to prepare for a possible loss and to prevent any further risk.

Reasons for Classified Loans

A decline in credit may alert banks and give them a reason to monitor a loan more closely. For example, if a borrower had a credit score of 750 and suddenly slipped to 650, the bank may look more closely at the account to see why such a dramatic decline occurred. This does not mean the account will be closed.

Unemployment or a significant decrease in salary may also draw attention to a loan account. Since the debt to income ratio changes when income is reduced, the borrower is considered to be a greater risk than before. Naturally less money in the borrowers hands increases the danger that payments will be missed, or that part of the interest and principal will not be repaid.

Sometimes the borrower's creditworthiness and income do not change, but there loan is deemed as a classified loan. This can happen is the loan is sold to another institution or a bank merger takes place. A different bank may have stricter lending standards and may not have approved certain loans if they had been approached by the applicant initially. The loan is not canceled, but it is monitored closely.

Once a loan is monitored, credit will no longer be extended. Also, a lender will begin to place collection calls much quicker than they would with a loan that is not monitored. However, that is the only difference, none of the loan terms can be changed.

Pros and Cons of Classified Loans

Financial institutions can benefit from categorizing certain loans as classified. They can prepare for a possible write-off if they see an increased risk before the loan defaults. They can also reduce risk by not extending further credit to a borrower who could possibly fail to pay the already due money in a timely fashion.

When a bank has multiple classified loans, they prepare to cover possible loss by raising rates for other borrowers. In order to prevent bankruptcy or significant loss of capital, interest rates and other lending fees are increased as an offset fee.

While this negative status may not appear on a credit report, having such a status with a bank can reduce the chances of the borrower gaining further credit. Should the borrower apply for further credit and they are denied, that will appear of the credit report and can impact their score negatively.