Default risk is the possibility that a borrower may not be able to pay back a loan. Lenders assess a borrower’s risk of default before lending funds, and high-risk loans may carry higher interest rates or be denied altogether. Secured loans, such as home or car loans, have options for lenders if a borrower defaults, but unsecured loans, such as credit cards, carry a higher risk. Lenders use credit scores to rank potential borrowers, and corporations and governments are also classified as default risk.
A default risk is defined as the possibility that a borrower will not be able to pay the principal or interest associated with a loan. Banks often assess a potential borrower’s risk of default before lending funds. The loan, if determined to be high risk, may carry a higher interest rate or may be denied altogether.
In a secured line of credit, such as a home or car loan, the risk of default is very significant, but the lender also has options if the borrower is unable to pay. A house can be repossessed and a car can be repossessed, in the event of a loan default. However, this process is typically labor intensive and can cost thousands of dollars to complete. In many cases, the lender may not get the full value of the loan repaid, but recovering at least a portion of the losses is a priority.
The greatest risk of default involves unsecured lines of credit, such as credit cards. With an unsecured line of credit, it may be impossible for the lender to recover much of the investment, in the event of a default. Therefore, credit cards and other unsecured lines of credit carry a higher risk when a default occurs. For this reason, these types of loans can be more difficult to acquire than other types that use equity as collateral.
In some cases involving people with a low risk of default, a credit card company may offer an interest rate as low or nearly as low as the borrower can find with a secured loan. This is often a marketing strategy used to attract consumers with good credit. However, if a payment is missed, or even late, the interest rate can triple, possibly even quadruple. Once the rate is increased, you can stay at that point for the life of the account.
To assess individuals’ risk of default, lenders can use scores obtained by one of the three major credit bureaus to rank potential borrowers. A higher score better indicates a better credit rating and lower risk for the lender. The average credit score in the United States is 723. However, lenders are not required to offer a loan on extremely favorable terms, since the consumer has a credit score higher than this.
Just like individuals, corporations and governments are also classified as default risk. Instead of a credit rating, the default risk associated with these entities is rated from AAA to D. Anything below a BBB rating is considered a junk bond. The risk of default with these types of bonds is higher, but the interest rate is also higher. It is up to each individual investor to determine if the reward outweighs the risk.
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