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What is Default Probability?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 28 October 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Default probabilities refers to the potential of debtors to fail to pay off loans or other debt obligations according to the terms and conditions put in place by lenders. When evaluating an application for credit, a loan, or a mortgage, lenders consider a number of different factors to determine if there is a greater chance of default at some point during the course of the business relationship. It is not uncommon for lenders to revisit the issue of default probability, in the event that the debtor undergoes some sort of shift in financial capability. For example, the loss of a job, a divorce, or any other factor that could inhibit the ability of the client to honor his or her obligation would prompt the lender to reassess the opportunity for default.

Accurately identifying the default probability is important for lenders. Doing so makes it easier to assess the degree of risk associated with approving the loan or credit application. Assuming the default risk is somewhat low, and the applicant meets all other qualifications, there is a good chance that the application will be approved, and a lower rate of interest extended. When the probability of default is somewhat higher, the lender may still be willing to assume the risk and approve the application, but only at a higher interest rate. Should the lender feel the default probability is too high, he or she will most likely reject the application.

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While any lending situation requires the determination of default probability, the purchase of a major asset often calls for more stringent assessments. An individual who wishes to purchase a home normally must have a decent credit rating, a steady income of a certain level, demonstrate an ability to manage current debt obligations with no apparent problems, and generally exhibit responsible behavior when it comes to financial matters. Since a mortgage is a long-term debt obligation, the lender will look very closely at all relevant factors and make sure there is a strong chance of repayment of the loan within the terms specified in the mortgage contract, before ever approving the mortgage.

Businesses also must demonstrate a low default probability when attempting to secure financing. Here, the overall financial stability of the company is very important, as well as the short-term and long-term outlook for the continuance of the business. Even if the company is currently in a solid financial position, a lender may choose to turn down the application if the product line of the business is one that is rapidly becoming obsolete. This is because the potential for default on the loan once that product line is no longer desirable to consumers increases considerably. For this reason, the lender may not be willing to take the chance, unless the company is planning to phase in a new product line that is likely to have more enduring appeal, and thus increase the chances of maintaining a healthy revenue stream.

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