What is Default Probability?
The default probability is a financial term used to quantify the borrower’s inability to make scheduled repayments over a specific period of time. The risk management committee of the company applies the default probability to a file for various credit analysis processes.
Understanding Default Probability
Unlike the usual cases where only the borrowers' credit record was considered to provide a line of credit, default probability depends on the economic factors as well.
In case a prospective customer has a higher risk of defaulting on repayments, credit card companies generally levy a higher interest rate on credit.
Also, when evaluating the risk inherent with lending money to a prospective customer, various criteria, such as revenues, operating margin trends, and cash flows with respect to the company’s debt are also considered when determining the probability of default.
Breaking Down Default Probability
Consider an example where a prospective homebuyer applies for a loan to purchase a house. Now, the bank or financial institution will assess the applicant's probability of defaulting depending on his/her credit report and financial resources, such as collaterals.
Depending on the applicant’s default probability, the lender will decide the rate of interest applicable to the loan. In case the default probability assessed on the applicant is low, the interest rate offered to the applicant will be lower as compared to the borrower whose probability of default is higher.
The default probability of a borrower is primarily indicated in the credit score. Credit scores are widely used by lenders to assess a borrower’s probability of default. The lower the credit ratings are, the higher interest rates the lender would charge on the borrower.
