Budgeting Debt Loans

Loan Loss Provisioning Explained

The lending industry can be confusing at times, especially when you are not familiar with the financial terms regularly used by banks and other financial institutions. Although there is a significant amount of knowledge to absorb, educating yourself on various aspects of the banking industry can empower you as a customer and borrower.

What Is a Loan Loss Provision?

Within the banking and lending industry, a loan loss provision is a particular type of income statement expense. This expense is set aside to be an allowance for loans that go uncollected and loan payments that go unpaid. Put plainly, the bank or other financial institution sets aside money to account for loan losses that occur when customers default, declare bankruptcy, or renegotiate loans. 

Loan loss provisions are added to the loan loss reserves, which is a balance sheet representing the total amount of loan losses minus the bank or company’s overall loans. Loan loss provisions can help cover banks and lenders when anticipated funds are missing because borrowers are delinquent on their loans or unable to pay them back.

How Do Loan Loss Provisions Work?

The lending industry brings in revenue to sustain its business through interest and other costs associated with lending products. When consumers, small businesses, or large corporations miss loan payments or default on their loans, the bank or lender’s revenue takes a major hit. 

A loan loss provision can be thought of as an internal insurance fund to protect lending companies from the financial damage that credit losses can cause. Every bank or corporation that deals with lending products has a certain amount of expected credit loss. Being equipped with sufficient loan loss provisions minimizes the negative impact those credit losses might have on a lender’s revenue.

Loan loss provisions are calculated based on the expected credit loss. The goal is to have a loan loss provision as close as possible to the anticipated loan loss. However, lenders can’t always accurately predict the expected credit losses, so there are bound to be discrepancies on the balance sheet occasionally. 

When trying to predict the size of their loan loss provisions ought to be, lenders seek to determine future expected losses through loan defaults, late payments, collection expenses, etc. The company will typically attempt to calculate an estimate using previous loss history and competitive analysis of the industry standard.

Some banks or lenders choose to divide their loan loss reserves into two categories allowing them to flag riskier loans for a more extensive loan loss provision. 

The Texas Ratio

The Texas Ratio is a calculation used to measure the bank or lender’s non-performing loans compared to the loan loss reserves. A company’s Texas Ratio is found by dividing the amount of the non-performing loan loss by the total tangible equity capital plus the loan loss reserves. If the amount of loan loss expenses exceeds the available capital in the loan loss provision, the bank or lending company could be in financial trouble. 

The 2008 Financial Crisis

A notable aspect of the 2008 financial crisis is that many banks did not have enough loan loss provisions to account for the actual losses that occurred. This big blow to the banking and lending industry made a significant difference in the typical loan loss provisions allocated for potential loan defaults. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 made grants available to increase loan loss reserve funds.

The onset of the 2020 recession has also caused banks to review their loan loss provisions and reserves to ensure they are prepared for any further economic decline. Banks and other lenders are doing all that they can do to avoid finding themselves in a similar situation to the 2008 financial crisis by being overly cautious in their bulking up of loan loss reserves. 

Obtaining a Loan With Poor Credit

Since loan repayment, interest, and other associated fees are how lenders and banks generate revenue, most of these financial institutions care about a borrower’s creditworthiness. A borrower with bad credit is more likely to pose a severe risk of financial loss to a bank or other lender. 

The inability to obtain funding can be incredibly aggravating for consumers with a less than perfect credit score. It can be challenging to be approved for loans with poor credit scores, but there are some reliable options that subprime borrowers can turn to in times of need.

Subprime Lending

While most loans have particular standards when it comes to the borrower’s credit report, there are some loans that are designed specifically for subprime consumers. Loans for people with bad credit include auto title loans, payday loans, online no credit check loans, and other cash loans that are fast. These loans tend to be short-term and high-interest, which can make them costly, but they can be an excellent last resort option when you are in a pinch. 

Lending options made for individuals with bad credit are at-risk for predatory lending, so it is important to do research on the online lenders you are considering. You will want to make sure that they are trustworthy. Before signing any contract, look into the repayment schedule and what you can realistically afford because missing payments can lead to detrimental consequences on your credit report. 

Credit-Building Tools

Some banks and financial institutions offer lending products that can be used by customers with poor or minimal credit history to build a better credit score. Products like a credit-builder loan and a secured credit card allow consumers to place a cash deposit for a secured loan or credit line. The lender will then report the payments to the credit bureaus as if it was a standard loan or credit card to improve the borrower’s payment history and credit mix. 

These credit-building lending products are excellent recovery options for people who have recently filed for bankruptcy or experienced some other credit-damaging financial crisis. A secured credit card or credit-builder loan is perfect for working your way up to normal credit cards and other mainstream lending products. 

Tips For Improving Your Credit

If you wish to improve your overall chances of being approved for loans and other various forms of credit, it is a good idea to put effort into cleaning up your credit report. Our consumer credit report plays an incredibly impactful role in our day to day lives, from funding approval to renting apartments. 

Luckily, you are not stuck with a bad credit score, as there are many actions you can take to improve it over time. Here are a few ways in which you can make your credit report far more appealing to lenders who are keeping their loan loss provisions in mind: 

Decrease Credit Utilization

One of the ways to improve your credit with nearly immediate results is to decrease your overall credit utilization ratio. The credit utilization ratio is the amount of debt you have compared to the available credit you have left unused. Your credit utilization rate is heavily relied upon by lenders as a marker for your overall credit health. 

Most financial experts advise that your credit utilization ratio should remain at 30% or below. If you are able to pay off a significant portion of your debt so that your credit utilization drops below 30%, you will likely see a major difference in your credit score. 

Once you’ve paid down most of your debt, you can aim to start paying off the balances of your credit cards every month. This will keep your credit report in excellent condition and make it easier for you to be on time with all your loan payments. 

Make On-Time Payments

Never miss payments or make them late for any of your loans or credit cards. Your payment history makes up the most considerable percentage of your credit score calculation. Late or missed payments bring down your creditworthiness and harm your credit score. Making on-time payments consistently will improve your payment history and boost your score. 

Paying more than the minimum payment on your credit cards and making extra payments on your loans without prepayment penalties will not only improve your credit but also help you pay off your debt faster and save you money. 

Have Patience

One of the most important things to keep in mind when it comes to your credit score is that you are unlikely to see results overnight. You can’t expect to make one change and have your score jump one hundred points overnight. The key to improving your credit report is to be consistent and patient. 

Keep up with your on-time payments and debt repayment strategies. Don’t give up, and keep making positive changes that will be good for your overall financial health. Include new types of credit or have yourself added as an authorized user on a family member’s credit card. Be creative and be patient. In time, you will see a total transformation of your credit report and score that reflects a prime borrower that all lenders will want to work with. Before you know it, you will have pre-approval offers and competitive interest rates coming at you from left and right. 

Loan loss provisions – Financial Pipeline