Prompt loan repayment culture is essential for the well-being of the borrower as well as the financial institution that gives the loan. Increasingly, borrowers are defaulting on loans and do not understand the importance of paying the loan on time. Some borrowers cheat the financial institution by doing frauds, and such borrowers pose a threat to the very system of borrowing and lending. They pose a collateral risk to the financial system. Let us now read on to see why loans must be repaid on time.
If the Borrower Does Not Make Prompt Loan Repayment? How Does It Affect The Lending institution?
When the borrower does not repay on time, it affects the lender in the following ways.
- Systematic flow of funds from banks and NBFCs is essential for economic and industrial growth. Many leading businesses and industrial ventures approach financial institutions for big loans. But if the financial institution is stuck with defaulted payments and bad loans, they will not be able to fund the next generation of entrepreneurs and traders.
- People trust financial institutions with deposits in the form of credit. They put the onus of safeguarding their money on financial institutions. If the number of defaulters and NPAs mount, then financial institutions will not be able to honor the commitments towards depositors. They are subject to liquidity risks with extensive risks and costs that ultimately impairs the stakeholder value.
The collapse of some banks and financial institutions due to the absence of a smart strategic plan, declining advances, and increasing NPAs are testimony to the crushing impact that payment defaults make. These banks and NBFcs tried their best to raise adequate capital to combat their negative net worth and losses but failed to do so.
How does late loan repayment affect the borrower?
Here are some ways in which defaulting on loans affects the borrower
- The borrower’s credit score will go in for a toss: The lending financial institution sends the information about the repayment patterns of the borrower to credit agencies in India. So, defaulting on payments will bring down the borrower’s credit score by a certain percentage. If the borrower defaults frequently, the financial institution will consider him as an NPA. This will affect his future chances of procuring loans even if he gets past the existing loans. Even if he manages to get loans, he will be charged higher interest rates as compared to those with good credit profiles.
- Penalties on Late Payments : The lending financial institution may impose penalties on defaulted payments. Hence, the borrower may end up paying a penalty on late payment in addition to his credit score being weakened. This is only an added financial burden for the borrower.
Thus as seen, defaulting on loan payments will affect the whole financial system of lending and borrowing.
Steps Financial Institutions Should Take for the Prevention of Late Payments and Recovery of Bad Loans
- Early Identification of the Problem: Prevention is always better than cure. Recognition of the problem in the early stages is essential, that is when the account starts showing signs of default. The financial institution does not have to wait for the account to become an NPA. Banks generally take steps for redeeming the money and also the project only after the problem multiplies and the consequences have been reaped. Whether revival is needed or not has to be decided based on viability, the stake and objective of the borrower, and if the assets can be recovered within a specific timeframe. In case the position of the asset or account is very bad, then it is better to wind up or sell it.
- Loan Recovery Tools
Loan recovery tools are used by financial institutions to recover bad loans. Some of them are, Lok Adalats, Sarfaesi Act, 2002, debt recovery tribunals, debt recovery appellate tribunals, compromise settlement schemes, credit information bureaus. Asset reconstruction companies, and the public money recovery act – 1988.
RBI granted license to form a bad bank – National Asset Reconstruction Company Ltd (NARCL) with an initial capital of Rs. 6000 crores. Banks can now move bad loans of Rs. 2 lakh crores to the bad bank. These bad loans will be fixed by experts who will sell the bad loans to potential investors.
Credit history is a very important tool for financial institutions to determine whom to give loans to and also for pricing of the loan (in terms of the interest rate, loan amount, tenure). Many borrowers are conscious of building a good credit history, since they want to stay in business, qualify for future loans, and enjoy the perks of best interest rates. Thus the RBI is planning to come up with the public credit registry – yet another credit storage bureau.
- Educating the Society About Prompt Loan Repayment Culture
Whatever loan recovery tools, legal recourse, or penalties the financial institution uses or imposes, the root cause of defaulting on loans comes from the borrowers’ ignorance about the importance of seamless flow of funds for economic and industrial growth. Thus, it is important to impart financial knowledge to the society and make them financially literate
Apart from the ways discussed above, there are many other methods which the financial institutions can use coupled with the borrowers’ financial discipline, which will enable a prompt loan repayment culture.