What it means
The phrase works in two directions. Applied to a person or business, impaired credit describes a damaged repayment record: missed payments, defaults, county court judgments, an arrangement with creditors or a bankruptcy.
Applied to a loan, it describes an asset the lender has decided will not be recovered in full. Lenders look for objective evidence rather than a hunch.
The usual triggers are significant financial difficulty at the borrower, a breach of contract such as missed instalments, a concession granted that the lender would not otherwise make, and any indication that bankruptcy or restructuring is likely. Once a loan is classed as impaired, accounting rules require the lender to recognise the expected loss immediately rather than waiting for the default to happen.
Modern standards go further and demand a forward-looking expected credit loss estimate on every loan, with a much larger provision once credit quality has fallen sharply. The mechanics of the provision are straightforward in concept.
The lender estimates the probability that the borrower defaults, the exposure at that point, and how much of the exposure would be lost after recoveries and collateral, then multiplies them to get the expected loss. From the borrower's side, impaired credit is expensive but rarely permanent.
Specialist lenders will still lend, at higher rates and lower loan to value ratios, and most negative records fall away from a credit file after a set number of years, so a rebuilt record of on-time payments gradually restores access to mainstream pricing.
In practice
Real-world examples.
Example
A couple applying for a mortgage disclose a default from four years earlier on a store card. Mainstream lenders decline, but a specialist lender approves the application at a rate roughly two percentage points higher and requires a 25% deposit rather than the usual 10%.
Example
A commercial bank reviews its portfolio of restaurant loans after a sharp fall in trade and moves twelve accounts into the impaired category. It books provisions covering the expected shortfall and begins restructuring talks with the operators before any of them formally default.
Example
A supplier extends 60-day terms to a retail chain that then announces store closures and delays payment twice. The finance director reclassifies the receivable as impaired, provides against part of it, and switches the customer to payment in advance for new orders.
Formula
Calculation
The standard expected loss calculation is: Expected credit loss = probability of default (PD) x loss given default (LGD) x exposure at default (EAD).
A commercial lender has a $400,000 loan to a haulage firm that has missed two consecutive payments and lost its largest customer. The credit team assesses a 30% probability of default over the next twelve months, and estimates that after selling the pledged vehicles it would recover 40% of the balance, so loss given default is 60%.
Expected credit loss = $400,000 x 30% x 60% = $72,000.
Carrying value after impairment = $400,000 - $72,000 = $328,000.
The lender books a $72,000 charge against profit and carries the loan at $328,000. If the firm later signs a replacement contract and the probability of default falls to 10%, the expected loss becomes $400,000 x 10% x 60% = $24,000, allowing $48,000 of the provision to be released back to profit.Case study
Seen in the real world.
This case is illustrative and the business named is fictional. Redstone Joinery, an invented cabinet maker, had a clean payment record until a main contractor collapsed owing it $180,000. Redstone missed three instalments on a $400,000 equipment loan while it chased the debt, and its bank moved the facility to the impaired category.
The immediate effects were harsh in this fictional example. The bank booked a provision, withdrew a $60,000 overdraft, and repriced the remaining loan on renewal. Two trade suppliers cut credit terms from 45 days to cash on delivery after seeing the change in Redstone's credit file, which squeezed working capital exactly when the business could least afford it.
The illustrative recovery took about two years. Redstone agreed a revised repayment schedule with the bank, made every payment on time, diversified so that no single contractor exceeded 15% of revenue, and rebuilt a small cash reserve. By the third year its credit score had recovered enough to secure a new facility at close to standard commercial rates, and the bank released most of the earlier provision.
Watch out
Common mistakes.
- Assuming impaired credit means no credit at all, when specialist lenders routinely lend to impaired borrowers at higher rates and lower loan to value ratios.
- Waiting for a formal default before recognising a problem, when accounting standards require provisions as soon as credit quality has clearly deteriorated.
- Treating an impairment charge as cash going out of the door, when it is an accounting estimate that can be reversed if the borrower's position improves.
Questions
People also ask.
How long does impaired credit follow a borrower?
Most negative entries drop off a credit file after roughly six years, though lenders weight recent behaviour most heavily, so consistent on-time payments improve the picture well before then.
Is an impaired loan the same as a bad debt?
No, an impaired loan is expected to be partly recoverable and is written down to that expected amount, whereas a bad debt is written off once recovery is considered hopeless.
Does restructuring a loan make it impaired?
Granting a concession you would not otherwise offer, such as a payment holiday or a rate cut for a struggling borrower, is one of the standard triggers, so yes in most cases it does.
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