What Is Toxic Debt?

Toxic debt represents any type of loan that has a lower chance of repayment when compared to other loans. Though a broad interpretation, it does include any form of loan a company or lender can make to individuals and businesses. The more common types of toxic debt are mortgages, car loans, and credit card debt, both consumer and business. The loans made to individuals may not initially fall under the toxic definition or group; they will, however, once the borrower cannot repay the loan. High-risk borrowers often fall in this category from the start of the loan, especially if their application documents indicate low income or unverified information.

The financial services industry usually has several regulations imposed upon it by government regulators. This helps prevent the default of loans and growth in toxic debt. When a government chooses to loosen banking rules, however, this can allow lenders to make riskier loans. These loans often include subprime mortgages, car loans to risky borrowers, and high-interest credit cards to low-qualified individuals. Any one of these latter loan groups can enter the toxic level from the very start as the application process does not tend to carry the same strict requirements as normal loans.

Many financial institutions carry large portfolios of loans on their books. These portfolios carry a broad group of loans made to borrowers for different reasons. The major groups include mortgages, automobile loans, and consumer credit lines. Credit cards may be a separate division in the financial institution and therefore kept separate from the traditional loan portfolio. Amongst the entire portfolio, the financial institution may make some allowance for toxic debt, which is a naturally occurring problem for most lenders.

Major problems can arise when a financial institution’s toxic debt reaches untenable levels. This most likely occurs for one of two reasons. First, the financial institution uses loose government regulations to increase loans to lower or previously unqualified borrowers. This often comes under the label of subprime mortgages or high-risk auto loans. Second, external economic factors make it increasingly difficult for borrowers to repay loans, forcing the institution to reclassify the loan as toxic debt.

Toxic debt may lead a financial institution to write off these loans against normal earnings. The result is lower profit for the lender and the potential to lose invested shareholders. Either way, the moniker for these loans is very descriptive for a very good reason.