Bad Debt

Financial Dictionary -> Debt -> Bad Debt

Bad debt is a term that falls on both sides of the spectrum, for lenders and for borrowers. In general it is a debt that either cannot be collected in the full amount or cannot be paid off in the full amount depending on which side you reside.

Financial institutions are aware that a portion of all loan capital will not be paid back due to bad debt. The hope is that interest paid on other loans makes up for the loss. This rarely occurs though, and on the accounts of the company, the bad debt can be listed as an expense.
There are many reasons why a borrower may end up in a situation where they have bad debts that cannot possibly be paid back. They may unexpectedly lose a job and therefore lack income, interest rates may rise beyond what they can pay, (this was a major part of the subprime mortgage fiasco during the economic crisis), or they may simply irresponsibly borrow beyond their means, for example through credit cards.

There is a lot of controversy in the fallout from the latest economic crisis as to where the fault lies for bad debt. Is it the lenders for openly giving loans to people that cannot pay them back, or is it the people borrowing beyond their means? Some claim that it is the natural theory of the business cycle, where banks relax their rules, give out lots of loans and promote a economic boom, then raise interest rates causing some borrowers to default, and the economy is brought back down.

If after a period of time a debt cannot be paid back, after various payment plans and measures have been out in place, the financial institution may sell on the debt to a debt collecting agency so their time and effort can be spent elsewhere. The law surrounding debt collecting agencies is cloudy, because the initial debt is not owed to them, but to the bank.