Default Probability: Definition for Individuals & Companies

What Is Default Probability?

Default probability is the likelihood that over a specified period, usually one year, a borrower will not be able to make their scheduled repayments on a particular debt. It can be applied to a variety of different risk management or credit analysis scenarios. Also called the probability of default (PD), it can depend not only on the borrower's characteristics, but also on the general economic environment.

Key Takeaways

  • Default probability, or probability of default (PD), is the likelihood that a borrower will fail to pay back a certain debt.
  • For businesses, probability of default is reflected in the company's credit ratings.
  • For individuals, a credit score is one gauge of default risk.
  • Lenders will typically charge higher interest rates when default probability is greater.
  • In the fixed-income market, high-yield bonds carry the greatest risk of default, and lower-yielding government securities are at the low-risk end of the spectrum.

How Default Probability Works

Creditors typically expect to receive a higher interest rate to compensate them for bearing higher default risk. Financial metrics—such as cash flows relative to debt, revenues or operating margin trends, and the use of leverage—are common considerations when evaluating the risk of lending to a particular company. The company's ability to execute a business plan is sometimes factored into the analysis, as well.

For businesses, a probability of default is implied by their credit rating from independent rating agencies, such as S&P Global Ratings, Fitch Ratings, or Moody's Investors Service. PDs may also be estimated using historical data and statistical techniques. PD is used along with "loss given default" (LGD) and "exposure at default" (EAD) in a variety of risk management models to estimate possible losses faced by lenders. Generally, the greater the default probability, the higher the interest rate the lender will charge the borrower.

Individuals can encounter the concept of default probability when they go to borrow money to purchase a residence. When a would-be home buyer applies for a mortgage, the lender makes an assessment of the buyer's default risk, based on their credit history and financial resources. The higher the estimated probability of default, the greater the interest rate that the borrower may have to pay (if the lender is willing to issue a loan at all). For consumers, a credit score, such as a FICO score, implies a particular probability of default.

High-Yield vs. Low-Yield Debt

The same logic comes into play when investors buy and sell fixed-income securities, like corporate bonds, on the open market. Companies that are cash-flush and have a low default probability will be able to issue debt at lower interest rates. Investors trading these bonds on the open market will price them at a premium compared to riskier debt. In other words, safer bonds will have a lower yield.

If a company's financial health worsens over time, investors in the bond market will adjust to the increased risk and trade the bonds at lower prices and therefore higher yields (because bond prices move in an opposite direction to yields). High-yield bonds have the highest probability of default and therefore pay a high yield or interest rate. At the other end of the spectrum are government bonds like U.S. Treasury securities, which typically pay the lowest yields and have the lowest risk of default; governments can always raise taxes or print more money to pay back their debt.

What Is Exposure at Default?

Exposure at default (EAD) refers to the amount of debt that is still outstanding on a loan when the borrower defaults. For example, if a defaulting borrower took out a loan for $50,000 and still owes $25,000, the lender's exposure at default is $25,000.

What Is Loss Given Default?

Loss given default (LGD), often referred to as loss severity, is a measure of how much money a lender stands to lose if the borrower defaults on a loan. It takes into account both the amount of debt outstanding at that particular point (the exposure at default) and how much money the lender might be able to recover by selling off the borrower's collateral or by other means. For example, if a borrower defaults on an auto loan, the lender may sell the car that served as collateral for it, thereby reducing its losses.

When Is a Loan Considered to Be in Default?

That depends on the lender and the type of loan. Typically a loan is considered to be in default after a certain number or months of missed payments. Some loans may be in default after as little as 30 days or one missed payment, while others can take far longer. Federal student loans may hold the record; they generally aren't considered to be in default until 270 days have elapsed. The credit bureau Experian says that, "Most lenders will not consider an account to be in default unless it is at least three to six months past due" although "a mortgage loan may be considered in default after only one missed payment." Before a loan is declared to be in default, lenders will generally classify it as delinquent and report it to the credit bureaus as such.

What Is the Effect of Default on the Borrower?

Not surprisingly, defaulting on a debt reflects poorly on the borrower, whether that's a company or an individual consumer, and can make it difficult or impossible for them to obtain further credit anytime soon. In the case of individuals, a default will remain on their credit reports for seven years and do considerable damage to their credit score, although the effect should diminish over time.

The Bottom Line

Default probability attempts to measure the likelihood that a particular borrower won't be able to fully repay a particular debt. It is used in both business and consumer lending and can have a major influence over the interest rate that a borrower will have to pay. The same concept applies when companies or governments look to borrow money by issuing bonds or similar securities.

Article Sources
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  1. Federal Student Aid. "Student Loan Delinquency and Default."

  2. Experian. "Will a Default Be Removed if It's Paid?"

  3. Experian. "Does Your Credit Score Go Up When a Default Is Removed?"