Note 3. Loans and the Allowance for Loan Losses

The following is a summary of the balances in each class of the Company's loan portfolio as of the dates indicated:

	March 31, 2017			December 31, 2016
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	95,392		$	94,827
Commercial		287,463			285,429
Construction		23,169			23,116
Second mortgages		17,496			17,128
Equity lines of credit		51,267			51,024
Total mortgage loans on real estate		474,787			471,524
Commercial loans		56,964			54,434
Consumer loans		87,111			58,907
Other		15,448			19,017
Total loans, net of deferred fees (1)		634,310			603,882
Less: Allowance for loan losses		(8,523	)		(8,245	)
Loans, net of allowance and deferred fees (1)	$	625,787		$	595,637

(1) Net deferred loan fees totaled $649 thousand and $522 thousand at March 31, 2017 and December 31, 2016, respectively.

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $585 thousand and $536 thousand at March 31, 2017 and December 31, 2016, respectively.

CREDIT QUALITY INFORMATION

The Company uses internally-assigned risk grades to estimate the capability of borrowers to repay the contractual obligations of their loan agreements as scheduled or at all. The Company's internal risk grade system is based on experiences with similarly graded loans. Credit risk grades are updated at least quarterly as additional information becomes available, at which time management analyzes the resulting scores to track loan performance.

The Company's internally assigned risk grades are as follows:

The following table presents credit quality exposures by internally assigned risk ratings as of the dates indicated:

Credit Quality Information As of March 31, 2017
	Pass		OAEM		Substandard		Total
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	92,812	$	1,125	$	1,455	$	95,392
Commercial		262,707		9,633		15,123		287,463
Construction		22,280		157		732		23,169
Second mortgages		16,815		467		214		17,496
Equity lines of credit		50,745		386		136		51,267
Total mortgage loans on real estate		445,359		11,768		17,660		474,787
Commercial loans		52,775		2,154		2,035		56,964
Consumer loans		86,974		0		137		87,111
Other		15,448		0		0		15,448
Total	$	600,556	$	13,922	$	19,832	$	634,310

Credit Quality Information As of December 31, 2016
	Pass		OAEM		Substandard		Total
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	92,458	$	1,138	$	1,231	$	94,827
Commercial		260,948		10,014		14,467		285,429
Construction		22,219		162		735		23,116
Second mortgages		16,445		475		208		17,128
Equity lines of credit		50,387		500		137		51,024
Total mortgage loans on real estate		442,457		12,289		16,778		471,524
Commercial loans		49,979		2,278		2,177		54,434
Consumer loans		58,741		0		166		58,907
Other		19,017		0		0		19,017
Total	$	570,194	$	14,567	$	19,121	$	603,882

As of March 31, 2017 and December 31, 2016, the Company did not have any loans internally classified as Loss or Doubtful.

AGE ANALYSIS OF PAST DUE LOANS BY CLASS

All classes of loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Interest and fees continue to accrue on past due loans until the date the loan is placed in nonaccrual status, if applicable. The following table includes an aging analysis of the recorded investment in past due loans as of the dates indicated. Also included in the table below are loans that are 90 days or more past due as to interest and principal and still accruing interest, because they are well-secured and in the process of collection. Loans in nonaccrual status that are also past due are included in the aging categories in the table below.

Age Analysis of Past Due Loans as of March 31, 2017
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Total Current Loans ⁽¹⁾		Total Loans		Recorded Investment > 90 Days Past Due and Accruing
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	618	$	123	$	391	$	1,132	$	94,260	$	95,392	$	0
Commercial		725		3,838		305		4,868		282,595		287,463		184
Construction		0		0		51		51		23,118		23,169		51
Second mortgages		83		0		53		136		17,360		17,496		0
Equity lines of credit		346		109		86		541		50,726		51,267		0
Total mortgage loans on real estate		1,772		4,070		886		6,728		468,059		474,787		235
Commercial loans		362		9		0		371		56,593		56,964		0
Consumer loans		1,382		509		2,789		4,680		82,431		87,111		2,708
Other		53		6		14		73		15,375		15,448		14
Total	$	3,569	$	4,594	$	3,689	$	11,852	$	622,458	$	634,310	$	2,957

⁽¹⁾ For purposes of this table, Total Current Loans includes loans that are 1 - 29 days past due.

In the table above, the consumer category includes student loans with principal and interest amounts that are 97 - 98% guaranteed by the federal government. The past due principal portion of these guaranteed loans totaled $4.3 million at March 31, 2017.

Age Analysis of Past Due Loans as of December 31, 2016
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Total Current Loans ⁽¹⁾		Total Loans		Recorded Investment > 90 Days Past Due and Accruing
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	564	$	0	$	496	$	1,060	$	93,767	$	94,827	$	218
Commercial		2,280		1,625		227		4,132		281,297		285,429		0
Construction		162		0		0		162		22,954		23,116		0
Second mortgages		0		200		188		388		16,740		17,128		58
Equity lines of credit		394		9		86		489		50,535		51,024		0
Total mortgage loans on real estate		3,400		1,834		997		6,231		465,293		471,524		276
Commercial loans		5		0		86		91		54,343		54,434		0
Consumer loans		1,876		713		2,684		5,273		53,634		58,907		2,603
Other		41		12		5		58		18,959		19,017		5
Total	$	5,322	$	2,559	$	3,772	$	11,653	$	592,229	$	603,882	$	2,884

⁽¹⁾ For purposes of this table, Total Current Loans includes loans that are 1 - 29 days past due.

Although the portion of the student loan portfolio that is 90 days or more past due would normally be considered impaired, the Company does not include these loans in its impairment analysis. Because the federal government has provided guarantees of repayment of these student loans in an amount ranging from 97% to 98% of the total principal and interest of the loans, management does not expect significant increases in past due student loans to have a material effect on the Company.

NONACCRUAL LOANS

The Company generally places commercial loans (including construction loans and commercial loans secured and not secured by real estate) in nonaccrual status when the full and timely collection of interest or principal becomes uncertain, part of the principal balance has been charged off and no restructuring has occurred or the loan reaches 90 days past due, unless the credit is well-secured and in the process of collection.

Under regulatory rules, consumer loans, which are loans to individuals for household, family and other personal expenditures, and consumer loans secured by real estate (including residential 1 - 4 family mortgages, second mortgages, and equity lines of credit) are not required to be placed in nonaccrual status. Although consumer loans and consumer loans secured by real estate are not required to be placed in nonaccrual status, the Company may elect to place these loans in nonaccrual status, if necessary to avoid a material overstatement of interest income. Generally, consumer loans secured by real estate are placed in nonaccrual status only when payments are 120 days past due.

Generally, consumer loans not secured by real estate are placed in nonaccrual status only when part of the principal has been charged off. If a charge-off has not occurred sooner for other reasons, a consumer loan not secured by real estate will generally be placed in nonaccrual status when payments are 120 days past due. These loans are charged off or written down to the net realizable value of the collateral when deemed uncollectible, when classified as a "loss," when repayment is unreasonably protracted, when bankruptcy has been initiated, or when the loan is 120 days or more past due unless the credit is well-secured and in the process of collection.

When management places a loan in nonaccrual status, the accrued unpaid interest receivable is reversed against interest income and the loan is accounted for by the cash basis or cost recovery method, until it qualifies for return to accrual status or is charged off. Generally, loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or when the borrower has resumed paying the full amount of the scheduled contractual interest and principal payments for at least six months.

The following table presents loans in nonaccrual status by class of loan as of the dates indicated:

Nonaccrual Loans by Class
	March 31, 2017		December 31, 2016
	(in thousands)
Mortgage loans on real estate
Residential 1-4 family	$	707	$	598
Commercial		10,000		6,033
Second mortgages		53		129
Equity lines of credit		86		87
Total mortgage loans on real estate		10,846		6,847
Commercial loans		105		231
Consumer loans		81		81
Total	$	11,032	$	7,159

The following table presents the interest income that the Company would have earned under the original terms of its nonaccrual loans and the actual interest recorded by the Company on nonaccrual loans for the periods presented:

	Three Months Ended March 31,
	2017			2016
	(in thousands)
Interest income that would have been recorded under original loan terms		$	117	$	85
Actual interest income recorded for the period			87		38
Reduction in interest income on nonaccrual loans		$	30	$	47

TROUBLED DEBT RESTRUCTURINGS

The Company's loan portfolio includes certain loans that have been modified in a troubled debt restructuring (TDR), where economic concessions have been granted to borrowers who are experiencing financial difficulties. These concessions typically result from the Company's loss mitigation activities and could include reduction in the interest rate below current market rates for borrowers with similar risk profiles, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. The Company defines a TDR as nonperforming if the TDR is in nonaccrual status or is 90 days or more past due and still accruing interest at the report date.

When the Company modifies a loan, management evaluates any possible impairment as stated in the impaired loan section below.

The following table presents TDRs during the period indicated, by class of loan.

Troubled Debt Restructurings by Class
For the Three Months Ended March 31, 2017
(dollars in thousands)
	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on March 31, 2017
Mortgage loans on real estate:
Residential 1-4 family		1	$	142	$	142	$	142

Troubled Debt Restructurings by Class
For the Three Months Ended March 31, 2016
(dollars in thousands)
	Number of Modifications		Recorded Investment Prior to Modification		Recorded Investment After Modification		Current Investment on March 31, 2016
Commercial loans		1	$	152	$	152	$	115

The loans restructured in the first three months of 2017 and 2016 were given below-market rates for debt with similar risk characteristics. At March 31, 2017 and December 31, 2016, the Company had no outstanding commitments to disburse additional funds on any TDR. At December 31, 2016, the Company had $10 thousand in loans secured by residential 1 - 4 family real estate that were in the process of foreclosure. There were no loans secured by residential 1 - 4 family real estate in the process of foreclosure at March 31, 2017.

In the first quarters of 2017 and 2016, there were no defaulting TDRs where the default occurred within twelve months of restructuring. The Company considers a TDR in default when any of the following occurs: the loan, as restructured, becomes 90 days or more past due; the loan is moved to nonaccrual status following the restructure; the loan is restructured again under terms that would qualify it as a TDR if it were not already so classified; or any portion of the loan is charged off.

All TDRs are factored into the determination of the allowance for loan losses and included in the impaired loan analysis, as discussed below.

IMPAIRED LOANS

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts when due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming loans and loans modified in a TDR. When management identifies a loan as impaired, the impairment is measured based on the present value of expected future cash flows, discounted at the loan's effective interest rate, except when the sole or remaining source of repayment for the loan is the operation or liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs, when foreclosure is probable, instead of the discounted cash flows. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through a specific allocation in the allowance or a charge-off to the allowance.

When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is in nonaccrual status, all payments are applied to principal under the cost-recovery method. For financial statement purposes, the recorded investment in the loan is the actual principal balance reduced by payments that would otherwise have been applied to interest. When reporting information on these loans to the applicable customers, the unpaid principal balance is reported as if payments were applied to principal and interest under the original terms of the loan agreements. Therefore, the unpaid principal balance reported to the customer would be higher than the recorded investment in the loan for financial statement purposes. When the ultimate collectability of the total principal of the impaired loan is not in doubt and the loan is in nonaccrual status, contractual interest is credited to interest income when received under the cash-basis method.

The following table includes the recorded investment and unpaid principal balances (a portion of which may have been charged off) for impaired loans with the associated allowance amount, if applicable, as of the dates presented. Also presented are the average recorded investments in the impaired loans and the related amount of interest recognized for the periods presented. The average balances are calculated based on daily average balances.

Impaired Loans by Class
	As of March 31, 2017												For the three months ended March 31, 2017
				Recorded Investment
	Unpaid Principal Balance			Without Valuation Allowance			With Valuation Allowance			Associated Allowance			Average Recorded Investment			Interest Income Recognized
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family		$	2,451		$	1,937		$	459		$	59		$	2,407		$	27
Commercial			16,892			11,728			4,288			674			16,232			201
Construction			619			527			95			20			620			13
Second mortgages			541			255			257			16			539			6
Equity lines of credit			87			86			0			0			87			0
Total mortgage loans on real estate		$	20,590		$	14,533		$	5,099		$	769		$	19,885		$	247
Commercial loans			1,987			507			1,392			359			1,928			31
Consumer loans			81			81			0			0			81			0
Total		$	22,658		$	15,121		$	6,491		$	1,128		$	21,894		$	278

Impaired Loans by Class
	As of December 31, 2016											For the Year Ended December 31, 2016
			Recorded Investment
	Unpaid Principal Balance		Without Valuation Allowance			With Valuation Allowance			Associated Allowance			Average Recorded Investment			Interest Income Recognized
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	2,496		$	1,835		$	622		$	75		$	2,741		$	119
Commercial		16,193			11,095			4,274			415			11,885			727
Construction		619			528			96			22			496			43
Second mortgages		526			309			141			17			511			25
Equity lines of credit		87			86			0			0			46			3
Total mortgage loans on real estate	$	19,921		$	13,853		$	5,133		$	529		$	15,679		$	917
Commercial loans		1,077			0			989			271			827			74
Consumer loans		81			81			0			0			68			1
Total	$	21,079		$	13,934		$	6,122		$	800		$	16,574		$	992

MONITORING OF LOANS AND EFFECT OF MONITORING FOR THE ALLOWANCE FOR LOAN LOSSES

Loan officers are responsible for continual portfolio analysis and prompt identification and reporting of problem loans, which includes assigning a risk grade to each applicable loan at its origination and revising such grade as the situation dictates. Loan officers maintain frequent contact with borrowers, which should enable the loan officer to identify potential problems before other personnel. In addition, meetings with loan officers and upper management are held to discuss problem loans and review risk grades. Nonetheless, in order to avoid over-reliance upon loan officers for problem loan identification, the Company's loan review system provides for review of loans and risk grades by individuals who are independent of the loan approval process. Risk grades and historical loss rates (determined by migration analysis) by risk grades are used as a component of the calculation of the allowance for loan losses.

ALLOWANCE FOR LOAN LOSSES

Management has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and probable losses inherent in the loan portfolio. The Company segments the loan portfolio into categories as defined by Schedule RC-C of the Federal Financial Institutions Examination Council Consolidated Reports of Condition and Income Form 041 (Call Report). Loans are segmented into the following pools: commercial, real estate-construction, real estate-mortgage, consumer and other loans. The Company also sub-segments the real estate-mortgage segment into four classes: residential 1-4 family, commercial real estate, second mortgages and equity lines of credit.

The Company uses an internally developed risk evaluation model in the estimation of the credit risk process. The model and assumptions used to determine the allowance are independently validated and reviewed to ensure that the theoretical foundation, assumptions, data integrity, computational processes and reporting practices are appropriate and properly documented.

Each portfolio segment has risk characteristics as follows:

Commercial: Commercial loans carry risks associated with the successful operation of a business or project, in addition to other risks associated with the ownership of a business. The repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much precision.
Real estate-construction: Construction loans carry risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the loan customer, may be unable to finish the construction project as planned because of financial pressure unrelated to the project.
Real estate-mortgage: Residential mortgage loans and equity lines of credit carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Commercial real estate loans carry risks associated with the successful operation of a business if owner occupied. If non-owner occupied, the repayment of these loans may be dependent upon the profitability and cash flow from rent receipts.
Consumer loans: Consumer loans carry risks associated with the continued credit-worthiness of the borrowers and the value of the collateral. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy.
Other loans: Other loans are loans to mortgage companies, loans for purchasing or carrying securities, and loans to insurance, investment and finance companies. These loans carry risks associated with the successful operation of a business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time, depend on interest rates or fluctuate in active trading markets.

ALLOWANCE FOR LOAN LOSSES AND RECORDED INVESTMENT IN LOANS
(in thousands)
For the Three Months Ended March 31, 2017	Commercial			Real Estate - Construction			Real Estate - Mortgage ⁽¹⁾			Consumer			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	1,493		$	846		$	5,267		$	455		$	184		$	8,245
Charge-offs		(138	)		0			(204	)		(33	)		(31	)		(406	)
Recoveries		8			0			4			4			18			34
Provision for loan losses		105			(259	)		463			342			(1	)		650
Ending balance	$	1,468		$	587		$	5,530		$	768		$	170		$	8,523
Ending balance individually evaluated for impairment	$	359		$	20		$	749		$	0		$	0		$	1,128
Ending balance collectively evaluated for impairment		1,109			567			4,781			768			170			7,395
Ending balance	$	1,468		$	587		$	5,530		$	768		$	170		$	8,523
Loan Balances:
Ending balance individually evaluated for impairment	$	1,899		$	622		$	19,010		$	81		$	0		$	21,612
Ending balance collectively evaluated for impairment		55,065			22,547			432,608			87,030			15,448			612,698
Ending balance	$	56,964		$	23,169		$	451,618		$	87,111		$	15,448		$	634,310

For the Year Ended December 31, 2016	Commercial			Real Estate - Construction			Real Estate - Mortgage ⁽¹⁾			Consumer			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	633		$	985		$	5,628		$	279		$	213		$	7,738
Charge-offs		(915	)		0			(504	)		(204	)		(147	)		(1,770	)
Recoveries		79			3			197			28			40			347
Provision for loan losses		1,696			(142	)		(54	)		352			78			1,930
Ending balance	$	1,493		$	846		$	5,267		$	455		$	184		$	8,245
Ending balance individually evaluated for impairment	$	271		$	22		$	507		$	0		$	0		$	800
Ending balance collectively evaluated for impairment		1,222			824			4,760			455			184			7,445
Ending balance	$	1,493		$	846		$	5,267		$	455		$	184		$	8,245
Loan Balances:
Ending balance individually evaluated for impairment	$	989		$	624		$	18,362		$	81		$	0		$	20,056
Ending balance collectively evaluated for impairment		53,445			22,492			430,046			58,826			19,017			583,826
Ending balance	$	54,434		$	23,116		$	448,408		$	58,907		$	19,017		$	603,882

⁽¹⁾ The real estate-mortgage segment includes residential 1 – 4 family, commercial real estate, second mortgages and equity lines of credit.

CHANGES IN ACCOUNTING METHODOLOGY

There were no changes in the Company's accounting methodology for the allowance for loan losses in the first three months of 2017.