A default risk is defined as the possibility that a borrower will not be able to pay back the principle or interest associated with a loan. Banks often assess the default risk of a potential borrower before lending funds. The loan, if it is determined to have a 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 default risk is very important, but the lender also has options should the borrower be unable to repay. A home can be foreclosed on and a car can be repossessed, in the event of a loan default. However, this process is usually very 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 biggest default risk involves unsecured lines of credit, such as credit cards. With an unsecured line of credit, it may be impossible for the lender to get back much of the investment, in case of a default. Credit cards and other unsecured lines of credit therefore carry a bigger risk when a default does occur. For this reason, these types of loans may be harder to acquire than other types that use the equity as collateral.
In some cases involving individuals with a low default risk, a credit card company may offer an interest rate as low, or nearly as low, as the borrower may be able to find with a secured loan. This is usually a marketing strategy used to attract consumers with a good credit history. However, if a payment is missed, or even late, the interest rate can triple, possibly even quadruple. Once the rate is increased, it may stay at that point throughout the life of the account.
To assess the default risk on individuals, lenders may use scores obtained by one of the three major credit bureaus in order to rank potential borrowers. A higher score indicates better a better credit rating and a lower risk for the lender. The average credit score in the United States is 723. However, lenders are under no obligation to offer a loan on extremely favorable terms, based on the consumer having a credit score higher than this.
Much like individuals, corporations and governments are also rated for default risk. Instead of a credit score, the default risk associated with these entities is graded from AAA to D. Anything below a BBB rating is considered a junk bond. The default risk with this type of bond is higher, but the interest rate is also higher. It is up to each individual investor to determine if the payoff outweighs the risk.