What is an unclassified loan?
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When you take out a loan to buy a vehicle or a house, you typically don’t actually own the car or property — the bank does. You are paying them until the loan is paid in full. This is known as a secured loan, where the loan is secured by putting up collateral. Conversely, unsecured loans do not require collateral. Student loans and credit cards, for example, simply require proof of income and an agreement to pay back the debt.
The loans will typically remain unclassified if the borrower stays in good standing and makes payments. If, for any reason, the bank gets the sense that the loan may not be paid back in full — perhaps the borrower had a change in job status or is late on a payment — the bank may decide to make it a classified loan. When that happens, the loan is marked as a potential default risk.
How do lenders classify loans?
Lenders classify loans when they meet a standard established by the Uniform Retail Credit Classification and Account Management Policy.
Consumer loans or credit accounts can fall into classified status if payment for the loan is past due or if the borrower has shown that they may no longer be able or willing to complete payments. This can include a sudden drop in the borrower’s credit score, a rise in unemployment, or other indicators that may suggest a new risk to the loan.
When lenders classify a loan, they use three categories:
- Substandard: A loan is classified as substandard if the bank deems the borrower shows any sort of risk of completing payment. It is used to designate when the bank should expect to experience some loss if conditions don’t change.
- Doubtful: Similar to substandard, a loan classified as doubtful suggests that the lender shouldn’t expect to collect its loan in full. It’s less of a warning, as substandard is, and more of an acknowledgment that the borrower will fail to pay back some of the loans.
- Loss: A loan classified as a loss means the bank has determined it makes more sense to write off the loan or asset rather than pursue recovery attempts like liquidation or repossession.
What happens if a lender decides a loan is unclassified?
If a lender decides that a loan is unclassified, it has not shown any potential risks of default that result in a loan becoming classified. Unclassified loans are being paid on time, the borrower is in good financial standing and the conditions of the borrower’s economic prospects remain sound.
An unclassified loan denotes the bank expects that the loan will be paid in full and on time and doesn’t show any elevated risks factors.
How does an unclassified loan affect your credit score and finances?
An unclassified loan will not affect your credit score other than the fact that taking on new debt or opening a new line of credit will impact it. As long as you make payments on time, you can expect your credit score to improve while you pay back your unclassified loan.
Likewise, having a loan that becomes classified does not necessarily impact your credit. Loans can become classified even when a borrower has not yet failed to make a payment. It is an internal measurement for the bank to prepare its balance sheet and account for any potential risks that might lead to a loss of money. It is not reported to the credit bureaus.
The loan is reported to the credit bureau, as are any payments or non-payments. But the classified status is a metric the bank uses to measure risk, not to determine your creditworthiness.
How do you prevent a loan you have from becoming classified?
Having a loan become classified does not necessarily mean that you’ve done something wrong. It does mean that something has changed about your financial status — perhaps a loss of income such as a layoff or unemployment, or a significant change in your credit score, such as opening a new line of credit or taking out a large loan. These can be indicators that you are more of a risk than you initially were and may result in the bank classifying the loan.
In most cases, though, banks will classify a loan as a result of late payments. If it has been more than 90 days without payment, a loan will typically be classified — though a secured loan may have more leeway, as there is collateral that the bank can use to recoup losses if needed.
Having a loan go from unclassified to classified does not necessarily mean that you are at risk of default. It’s a metric the bank uses to measure potential risk and can be affected by many things. However, it is most likely that an unclassified loan becomes classified as the result of missed payments. Make sure to make payments on time to avoid classified status.