What it means
Every loan portfolio changes over time as borrowers make payments, some repay early and investments reach maturity. If the lender stops adding new loans, the total balance falls, which is called runoff.
If the lender keeps lending, new business offsets runoff and the portfolio may stay steady or grow. Runoff is measured as a rate, such as 20% a year, or as an expected schedule of balances.
The rate depends on the type of asset: short-term consumer loans run off quickly, while long-term mortgages run off slowly. It also depends on interest rates, since falling rates encourage borrowers to repay early and refinance.
Businesses care about runoff for several reasons. It determines how much interest income will fall if no new loans are made, how much cash will come back for reinvestment, and how funding must be adjusted as assets shrink.
A bank exiting a product line, for example, plans its funding and staffing around the expected runoff of that book. Runoff also matters for valuation and risk.
Buyers of a closed portfolio estimate the cash it will produce as it winds down. Managers of a legacy portfolio watch for the point at which the remaining balance is too small to cover the fixed costs of servicing it.
The term is related to run-off in insurance, where a company stops writing new policies and simply pays out remaining claims. In both cases, the focus is on managing the existing book until it is gone, while keeping costs and risks under control.
Planning for runoff includes deciding whether to let the book wind down naturally, sell it to another institution or actively manage it for better recoveries. The finance team should model all three options before choosing.
Each choice affects income, capital and reputation.
In practice
Real-world examples.
Example
A bank stops offering a type of personal loan. Its finance team forecasts how quickly the existing loans will be repaid so it can plan funding and staff. The forecast shows the loan book falling by about a fifth each year.
Example
An insurer closes a line of business to new customers. It manages the remaining policies until all claims are settled, tracking the declining reserves each quarter. The insurer keeps a small team to handle claims until the last one closes.
Example
An investor buys a closed portfolio of car loans from a lender. The investor models the monthly runoff to estimate the cash it will receive over the next four years. A faster runoff would return its money sooner, but at a lower total interest.
Formula
Calculation
Balance after n years = starting balance x (1 - annual runoff rate)^n
Suppose a lender has a $100,000,000 portfolio and expects 20% runoff each year with no new lending.
After year 1: 100,000,000 x 0.80 = $80,000,000.
After year 2: 80,000,000 x 0.80 = $64,000,000.
After year 3: 64,000,000 x 0.80 = $51,200,000.
If the portfolio earns 6% interest, income in year 1 on the opening balance is 100,000,000 x 0.06 = $6,000,000, and income in year 3 on its opening balance of $64,000,000 is 64,000,000 x 0.06 = $3,840,000.Case study
Seen in the real world.
Granite Bay Bank is a fictional lender that decides to exit its student loan business, which has $100,000,000 of balances. In this illustrative plan, the finance team expects 20% annual runoff and no new lending. Balances would fall to $80,000,000, $64,000,000 and $51,200,000 over the next three years.
The team calculates that interest income at 6% would drop from $6,000,000 to $3,840,000 by year three, while servicing costs of $1,500,000 a year are mostly fixed. By year four, the remaining income no longer covers the costs of running the portfolio.
The bank decides to sell the remaining balance at the end of year three to a specialist servicer. The decision avoids years of loss-making administration and releases staff and systems for other business.
Watch out
Common mistakes.
- Forgetting that fixed costs do not fall as fast as balances. A shrinking portfolio can become unprofitable.
- Assuming a constant runoff rate. Changes in interest rates and the economy can speed or slow repayment.
- Ignoring funding. As assets run off, the lender must repay or reinvest the money that funded them, and a mismatch can leave it holding cash that earns less than it pays.
Questions
People also ask.
Is runoff the same as default?
No. Runoff is the planned or voluntary reduction in balances, while default is a failure to repay, although both reduce the outstanding balance of the portfolio.
Why do lenders sell closed portfolios?
To avoid the costs of servicing a shrinking book and to release capital sooner, though the sale price is usually a little below the face value of the loans.
How is runoff forecast?
From historical repayment patterns, loan terms and assumptions about early repayment, often with a different curve for each product, and the forecast is checked against actual results every month.
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