What is a Probability of Default?

Jessica Ellis

The probability of default is the likelihood that a borrower will be unable to repay debts, sending a loan into default. Measuring this probability is one of the ways that financial institutions manage credit risk, both to individual borrowers and in lending funds to businesses or corporations. Banks and lenders may analyze a variety of factors to determine probability of default, including current assets, credit score or rating. In some cases, interest rates may go up or down, or loans may become accessible or unavailable, depending on the assumed probability of default.

Credit history is one indicator that determines a lender's assumption of probability of default.
Credit history is one indicator that determines a lender's assumption of probability of default.

Creditors survive by making more in interest and fees than they lend out. When a loan goes into default, a creditor stands a serious chance of losing some or all of the funds in that loan, despite some legal proceedings that may be undertaken to recover part of the lost income. One way that lending institutions protect their own profits is by setting careful lending standards with regard to probability of default. By imposing high interest rates on riskier loans, creditors can start earning profits off the loan before it has the chance to go into default.

Different companies may use different methods to create a scale for lending that includes the default probability. One way probability is measured for businesses is by comparing the company currently seeking a loan to the proven default level of past companies with similar assets, makeups, and risk factors. Financial institutions may also rely on credit or investment grades given by independent agencies to help determine levels of probability; companies with grades lower than a “B” are usually considered a much higher risk than those above this level.

Individuals may have to rely on their credit history, income, and assets to inform a lender's assumption of probability of default. Those who have had credit problems, a bankruptcy, or incomes that do not compare well to the level of loan repayments may have difficulty getting a loan at all, let alone favorable interest rates. While the fact that people with assets and high incomes have an easier time borrowing money may seem counterintuitive, it is a widely-used means of protecting investments in the lending industry. For those denied access to loans or reasonable interest rates due to a high probability of default rating, experts sometimes recommend spending another six months to a year trying to improve credit scores and boost asset levels, then trying again.

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