TDR impairment: What is the effective interest rate?

Oct 21, 2015

The OCC’s recent update to its Bank Accounting Advisory Series (BAAS) provided views on accounting topics relevant to national banks and federal savings associations, and one addition to the guidance answered the question, “How is the effective interest rate determined when measuring impairment of a TDR [troubled debt restructuring] loan?”

The OCC’s guidance, which is based on the “Residential Real Estate Lending” booklet issued in June, replaces previous advice based on the now-rescinded 2009 Thrift Bulletin 85 for TDRs of 1-4 residential mortgage loans.

The effective interest rate is the rate of return implicit in the original loan, the OCC said. In other words, it is the contractual interest rate adjusted for any net deferred loan fees or costs, premium or discount existing at the origination or acquisition of the loan.

“The effective interest rate represents the bank’s expected yield over the contractual life of the loan upon its origination or acquisition, and is the discount rate used to measure impairment using the present value of expected future cash flows method,” according to the BAAS update.

The effective interest rate should not be based on the interest rate charged under the modified terms of the loan. This is important, because interest-rate concessions are among the common ways lenders modify the loan structure as part of a TDR when the borrower has exhibited financial difficulties. The update noted that teaser and introductory rates shouldn’t be used, either, when determining the effective interest rate of a TDR.

What about loans with floating contractual interest rates? If a loan’s rate varies based on subsequent changes in an independent factor, such as an index or rate (for example, the prime rate, LIBOR, or the U.S. Treasury bill rate weekly average), banks have two options for determining the loan’s effective interest rate. The rate may be either:

  1. Calculated based on the factor as it changes over the life of the loan or
  2. Be fixed at the rate in effect at the date the loan meets the criterion for impairment.

The OCC says that whichever method is used should be applied consistently for those types of loans. In addition, banks should not consider projections of future changes in the factor when they are determining the effective interest rate or estimate of expected future cash flows, according to the accounting guidance.

See the updated BAAS guidance here (Question 27, page 36).

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Excerpt Pulled From Blog:

"When calculating the impairment of a loan deemed to be impaired, guidance requires that the loan should be evaluated using one of three valuation methods. Many institutions question how and when to use two of the valuation methods -- present value of cash flows and fair value of collateral -- in order to determine the impairment and potential reserve. There are key distinctions to these methods of calculation."

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