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, 2018			December 31, 2017
	(in thousands)
Mortgage loans on real estate:
Residential 1-4 family	$	102,428		$	101,021
Commercial		287,395			289,682
Construction		29,054			27,489
Second mortgages		18,721			17,918
Equity lines of credit		54,907			56,610
Total mortgage loans on real estate		492,505			492,720
Commercial and industrial loans		57,019			60,398
Consumer automobile loans		120,360			119,251
Other consumer loans		52,661			54,974
Other		10,330			11,197
Total loans, net of deferred fees (1)		732,875			738,540
Less: Allowance for loan losses		(9,731	)		(9,448	)
Loans, net of allowance and deferred fees and costs (1)	$	723,144		$	729,092

(1) Net deferred loan fees totaled $906 thousand and $916 thousand at March 31, 2018 and December 31, 2017, respectively.

Overdrawn deposit accounts are reclassified as loans and included in the Other category in the table above. Overdrawn deposit accounts totaled $662 thousand and $594 thousand at March 31, 2018 and December 31, 2017, 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:

	Pass: Loans are of acceptable risk.

	Other Assets Especially Mentioned (OAEM): Loans have potential weaknesses that deserve management's close attention.

	Substandard: Loans reflect significant deficiencies due to several adverse trends of a financial, economic or managerial nature.

	Doubtful: Loans have all the weaknesses inherent in a substandard loan with added characteristics that make collection or liquidation in full based on currently existing facts, conditions and values highly questionable or improbable.

	Loss: Loans have been identified for charge-off because they are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.

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

Credit Quality Information
As of March 31, 2018
(in thousands)
	Pass		OAEM		Substandard		Doubtful		Total
Mortgage loans on real estate:
Residential 1-4 family	$	100,314	$	450	$	1,664	$	-	$	102,428
Commercial		259,935		13,770		13,690		-		287,395
Construction		28,259		73		722		-		29,054
Second mortgages		18,000		538		183		-		18,721
Equity lines of credit		54,597		-		310		-		54,907
Total mortgage loans on real estate		461,105		14,831		16,569		-		492,505
Commercial and industrial loans		54,598		1,833		588		-		57,019
Consumer automobile loans		119,930		-		430		-		120,360
Other consumer loans		52,446		-		215		-		52,661
Other		10,330		-		-		-		10,330
Total	$	698,409	$	16,664	$	17,802	$	-	$	732,875

Credit Quality Information
As of December 31, 2017
(in thousands)
	Pass		OAEM		Substandard		Doubtful		Total
Mortgage loans on real estate:
Residential 1-4 family	$	98,656	$	-	$	2,365	$	-	$	101,021
Commercial		264,275		10,526		14,881		-		289,682
Construction		26,694		74		721		-		27,489
Second mortgages		17,211		431		276		-		17,918
Equity lines of credit		56,318		-		292		-		56,610
Total mortgage loans on real estate		463,154		11,031		18,535		-		492,720
Commercial and industrial loans		58,091		1,469		838		-		60,398
Consumer automobile loans		119,211		-		40		-		119,251
Other consumer loans		54,926		-		48		-		54,974
Other		11,197		-		-		-		11,197
Total	$	706,579	$	12,500	$	19,461	$	-	$	738,540

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, 2018
	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	$	554	$	-	$	347	$	901	$	101,527	$	102,428	$	-
Commercial		315		588		386		1,289		286,106		287,395		-
Construction		-		-		721		721		28,333		29,054		-
Second mortgages		53		-		45		98		18,623		18,721		45
Equity lines of credit		454		-		53		507		54,400		54,907		-
Total mortgage loans on real estate		1,376		588		1,552		3,516		488,989		492,505		45
Commercial loans		145		3		590		738		56,281		57,019		-
Consumer automobile loans		572		94		142		808		119,552		120,360		142
Other consumer loans		642		472		1,963		3,077		49,584		52,661		1,962
Other		51		9		16		76		10,254		10,330		17
Total	$	2,786	$	1,166	$	4,263	$	8,215	$	724,660	$	732,875	$	2,166

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

In the table above, the other consumer loans 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 $2.8 million at March 31, 2018.

Age Analysis of Past Due Loans as of December 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	$	229	$	153	$	1,278	$	1,660	$	99,361	$	101,021	$	261
Commercial		194		771		1,753		2,718		286,964		289,682		-
Construction		-		-		721		721		26,768		27,489		-
Second mortgages		15		-		163		178		17,740		17,918		45
Equity lines of credit		75		19		53		147		56,463		56,610		-
Total mortgage loans on real estate		513		943		3,968		5,424		487,296		492,720		306
Commercial loans		709		-		1,060		1,769		58,629		60,398		471
Consumer automobile loans		517		122		41		680		118,571		119,251		41
Other consumer loans		2,222		544		2,360		5,126		49,848		54,974		2,360
Other		84		9		4		97		11,100		11,197		4
Total	$	4,045	$	1,618	$	7,433	$	13,096	$	725,444	$	738,540	$	3,182

⁽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, 2018		December 31, 2017
	(in thousands)
Mortgage loans on real estate
Residential 1-4 family	$	1,226	$	1,447
Commercial		10,924		9,468
Construction		722		721
Second mortgages		118		118
Equity lines of credit		311		292
Total mortgage loans on real estate		13,301		12,046
Commercial loans		830		836
Total	$	14,131	$	12,882

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,
	2018			2017
	(in thousands)
Interest income that would have been recorded under original loan terms		$	130	$	117
Actual interest income recorded for the period			80		87
Reduction in interest income on nonaccrual loans		$	50	$	30

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 tables present TDRs during the periods indicated, by class of loan. There were no troubled debt restructurings originated in the three months ended March 31, 2018.

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

The one loan restructured in the first three months ended March 31, 2017 was given below-market rates for debt with similar risk characteristics. At March 31, 2018 and December 31, 2017, the Company had no outstanding commitments to disburse additional funds on any TDR. At March 31, 2018 and December 31, 2017, the Company had $204 thousand and $77 thousand, respectively, in loans secured by residential 1 - 4 family real estate that were in the process of foreclosure.

In the first quarters of 2018 and 2017, 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, 2018												For the three months ended March 31, 2018
				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		$	2,059		$	1,944		$	94		$	49		$	2,042		$	16
Commercial			16,290			14,245			436			164			15,596			93
Construction			813			722			91			17			814			1
Second mortgages			469			315			134			14			471			4
Equity lines of credit			312			53			258			29			312			-
Total mortgage loans on real estate		$	19,943		$	17,279		$	1,013		$	273		$	19,235		$	114
Commercial loans			1,109			830			-			-			836			-
Other consumer loans			170			-			168			68			169			4
Total		$	21,222		$	18,109		$	1,181		$	341		$	20,240		$	118

Impaired Loans by Class
	As of December 31, 2017											For the Year Ended December 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	$	2,873		$	2,499		$	316		$	52		$	2,525		$	90
Commercial		15,262			11,622			1,644			1			13,541			579
Construction		814			721			92			18			406			23
Second mortgages		473			318			135			14			464			20
Equity lines of credit		293			53			239			10			261			-
Total mortgage loans on real estate	$	19,715		$	15,213		$	2,426		$	95		$	17,197		$	712
Commercial loans		1,115			836			-			-			1,388			30
Other consumer loans		-			-			-			-			41			-
Total	$	20,830		$	16,049		$	2,426		$	95		$	18,626		$	742

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.

Each segment of the portfolio is pooled by risk grade or by days past due. Consumer loans not secured by real estate and made to individuals for household, family and other personal expenditures are segmented into pools based on days past due, while all other loans, including loans to consumers that are secured by real estate, are segmented by risk grades. A historical loss percentage is then calculated by migration analysis and applied to each pool. The migration analysis applied to all pools is able to track the risk grading and historical performance of individual loans throughout a number of periods set by management, which provides management with information regarding trends (or migrations) in a particular loan segment. At March 31, 2018 and December 31, 2017 management used eight twelve-quarter migration periods.

Management also provides an allocated component of the allowance for loans that are specifically identified that may be impaired, and are individually analyzed for impairment. An allocated allowance is established when the present value of expected future cash flows from the impaired loan (or the collateral value or observable market price of the impaired loan) is lower than the carrying value of that loan.

Based on credit risk assessments and management's analysis of qualitative factors, additional loss factors are applied to loan balances. These additional qualitative factors include: economic conditions, trends in growth, loan concentrations, changes in certain loans, changes in underwriting, changes in management and changes in the legal and regulatory environment.

ALLOWANCE FOR LOAN LOSSES BY SEGMENT

The total allowance reflects management's estimate of losses inherent in the loan portfolio at the balance sheet date. The Company considers the allowance for loan losses of $9.7 million adequate to cover probable loan losses inherent in the loan portfolio at March 31, 2018.

The following table presents, by portfolio segment, the changes in the allowance for loan losses and the recorded investment in loans for the periods presented. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

ALLOWANCE FOR LOAN LOSSES AND RECORDED INVESTMENT IN LOANS
(in thousands)
For the Three Months Ended March 31, 2018	Commercial			Real Estate - Construction			Real Estate - Mortgage ⁽¹⁾			Consumer ⁽²⁾			Other			Total
Allowance for Loan Losses:
Balance at the beginning of period	$	1,889		$	541		$	5,217		$	1,644		$	157		$	9,448
Charge-offs		(78	)		-			(125	)		(125	)		(79	)		(407	)
Recoveries		18			-			71			52			24			165
Provision for loan losses		190			(131	)		310			90			66			525
Ending balance	$	2,019		$	410		$	5,473		$	1,661		$	168		$	9,731
Ending balance individually evaluated for impairment	$	-		$	17		$	256		$	68		$	-		$	341
Ending balance collectively evaluated for impairment		2,019			393			5,217			1,593			168			9,390
Ending balance	$	2,019		$	410		$	5,473		$	1,661		$	168		$	9,731
Loan Balances:
Ending balance individually evaluated for impairment	$	830		$	813		$	17,479		$	168		$	-		$	19,290
Ending balance collectively evaluated for impairment		56,189			28,241			445,972			172,853			10,330			713,585
Ending balance	$	57,019		$	29,054		$	463,451		$	173,021		$	10,330		$	732,875

For the Year Ended December 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		(807	)		-			(1,934	)		(279	)		(267	)		(3,287	)
Recoveries		37			104			45			56			88			330
Provision for loan losses		1,166			(409	)		1,839			1,412			152			4,160
Ending balance	$	1,889		$	541		$	5,217		$	1,644		$	157		$	9,448
Ending balance individually evaluated for impairment	$	-		$	18		$	77		$	-		$	-		$	95
Ending balance collectively evaluated for impairment		1,889			523			5,140			1,644			157			9,353
Ending balance	$	1,889		$	541		$	5,217		$	1,644		$	157		$	9,448
Loan Balances:
Ending balance individually evaluated for impairment	$	836		$	813		$	16,826		$	0		$	-		$	18,475
Ending balance collectively evaluated for impairment		59,562			26,676			448,405			174,225			11,197			720,065
Ending balance	$	60,398		$	27,489		$	465,231		$	174,225		$	11,197		$	738,540

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

⁽²⁾ The consumer segment includes consumer automobile loans.