Default probability is the likelihood a borrower will be unable to meet their repayment obligations on a debt. This is typically measured over a specific time period, like a year. This financial term is also sometimes referred to as the probability of default (PD).
If a borrower is determined to have a high probability of default, the lender will either deny the loan request or charge higher interest rates. Understanding how to lower your default probability may be able to help you gain more favorable terms on lending products in the future.
Learn more about what default probability is and how it works.
Definition and Example of Default Probability
Default probability is the likelihood a borrower will default on a loan. It’s used in a variety of credit analysis and risk management frameworks.
Default probability considers not only the borrower’s credit history but also the current economic environment. Lenders typically charge higher interest rates to borrowers that are determined to have a high probability of default.
- Alternate name: Probability of default
- Acronym: PD
For instance, if a borrower applies for a mortgage, the lender will look at their monthly income and monthly expenses to determine whether they can afford the mortgage payments.
How Default Probability Works
Probability of default is an important risk assessment tool performed by lenders. It is determined largely by a borrower’s capacity to repay the loan, which is influenced by a variety of factors.
When a borrower applies for a loan, the first thing lenders will consider is the borrower’s financial health. For consumers, this is largely determined by their credit score and debt-to-income ratio. The lender will consider whether you made previous loan payments on time and if you were able to repay that loan in full. If a borrower has a poor credit score or is overextended due to other debts, this indicates they might have a harder time repaying their loan.
If you have a high default probability, that doesn’t necessarily mean the lender will deny your loan request. Instead, the lender may charge you a higher interest rate on the loan.
A higher interest rate help the lender compensate for the increased default risk. Borrowers can also share in the default probability by putting down collateral on the loan.
For businesses, lenders will usually consider the company’s cash flow, cash reserves, or any other assets on hand. A company may also be seen as less creditworthy if economic conditions aren’t in its favor. For instance, their business performance could be negatively impacted by challenges affecting their suppliers.
Default Probability and Ratings Agencies
Credit rating agencies like Fitch Ratings, Moody’s Investors Services, and Standard & Poor’s assess default probability. These agencies assign ratings to different types of bonds to help investors gauge the level of risk involved.
For instance, Moody’s assigns credit ratings based on the level of credit risk. An Aaa and Aa rating indicate high-quality obligations that are subject to little credit risk.
A Baa credit rating is subject to moderate risk; anything below that is considered a substantial credit risk. A higher rating isn’t a guarantee against default, but it indicates the ratings agency believes it’s less likely to default than a bond with a lower rating.
Default Probability and Credit Default Swaps
Any time a bank lends money to a consumer or business, there’s a chance the borrower won’t repay the loan. To hedge against this risk, lenders will sometimes utilize credit default swaps (CDS). A CDS is used as a form of insurance against non-payment.
A CDS is a contract that allows the lender to “swap” their credit risk with another investor. If a borrower has a high default probability, the lender will purchase a CDS from another investor who agrees to reimburse the lender if the borrower defaults.
- Default probability is the likelihood a borrower will fail to meet their repayment schedule on a loan or debt.
- If a borrower is determined to have a high default probability, they will likely have to pay higher interest rates on the loan.
- If a lender is concerned about the probability of default, they may purchase a credit default swap (CDS) to hedge against potential losses.