Default risk is the chance that borrowers will stop making monthly payments on their loans as outlined in their lending agreements. This possibility is also sometimes referred to as credit risk, and it’s something every lender or ratings agency has to consider when evaluating an individual or business.
Lenders will often compensate for a high default risk by charging higher interest rates or, in the case of businesses offering bonds, lower credit ratings. Learn how default risk works for both individuals and companies.
Definition and Examples of Default Risk
Default risk measures the likelihood that a borrower will fail to repay their loan obligations. A borrower has a higher default risk when they have a poor credit rating and limited cash flow.
For consumers, default risk can affect the rates and terms you'll qualify for if a lender sees you as a high default risk. It could even cause you to be denied a loan. Default risk doesn't apply only to borrowers who are looking to take out loans. It also relates to companies that issue bonds, and whether they’ll be able to make interest payments on these bonds.
- Alternate name: Credit risk
For example, a lender may reject your loan application because you’ve had a bankruptcy in the past year or have low credit scores due to multiple late payments on your credit report. A bond offered by a business may get a low credit rating because it has cash flow issues.
How Does Default Risk Work?
When a borrower takes out a loan, there’s always a chance that they won’t repay it. This default risk is something a lender considers with every borrower. But evaluating a borrower’s default risk is not a straightforward process. Several factors are considered.
For individuals, lenders will often look at a borrower’s credit score to determine the individual's level of risk and what kind of interest rates they should qualify for. A credit score is a three-digit number that evaluates how likely you are to repay your loan and make your payments on time.
Your credit score is calculated based on the information in your credit report. This includes your payment history, the number of accounts you have open, and your overall debt levels.
It’s a good idea to check your credit report regularly to make sure the information included here is accurate and correct. You can request a free copy of your credit report if you're turned down for a loan because of your credit score.
For companies, ratings analysts will often look at a company’s free cash flow and financial statements to determine a business's default risk. Free cash flow is calculated by subtracting a business’s capital expenditures from its operating cash flow. Companies with a poor cash flow could be a higher default risk, and therefore they may receive a lower credit rating.
Types of Default Risk in Investments
Rating agencies evaluate companies and investments to determine their level of risk. The lower the rating, the higher the level of risk. These ratings can be grouped into two different categories: investment grade and non-investment grade.
Investment Grade Ratings
Investment-grade debt has a low risk of default and is seen as more desirable by potential investors. Bonds with a Moody’s credit rating of Baa or a Standard & Poor’s (S&P) rating of BBB or higher are considered investment grade.
Non-Investment Grade Ratings
Non-investment grade securities have a Moody’s credit rating of Ba or lower and are considered high. Non-investment grade companies offer higher interest rates and a lower purchasing price due to increased risk. These are also sometimes called junk bonds.
- Default risk is the possibility that a borrower may stop making payments on a loan as outlined in the lending agreement.
- Lenders check a borrower’s credit score to determine whether they're a good candidate for a loan and the types of interest rates they qualify for.
- Default risk also applies to companies that issue bonds and whether they’ll be able to make the interest payments on those bonds.
- Businesses with a cash flow near zero or negative are seen as a higher default risk.
- Rating agencies, like Moody’s and S&P, categorize a company’s level of default risk as either investment grade or non-investment grade.