Default Risk: Definition, Types, and Measurement

Definition

Default risk is the likelihood that a borrower—an individual, company, or government—will fail to make required payments on a debt obligation (loan, bond, credit card). Higher default risk typically requires borrowers to pay higher interest rates to compensate lenders or investors.

Key takeaways

• Default risk is the probability a borrower won’t meet debt payments.
• Lenders assess default risk to set interest rates and lending terms.
• Consumer default risk is gauged through credit reports and scores.
• Corporate and sovereign default risk is assessed by financial analysis and credit rating agencies.
• Higher default risk usually means higher borrowing costs or reduced access to credit.

How default risk is determined

Lenders and investors evaluate the likelihood of nonpayment by reviewing borrower-specific financial information and broader economic conditions. For consumers, credit history and credit scores are primary tools. For companies and governments, financial statements, cash flows, leverage, and ratings from agencies such as S&P, Moody’s, and Fitch are commonly used.

Measuring a company’s default risk

Common methods and indicators:

• Free cash flow: operating cash flow minus capital expenditures. Near-zero or negative free cash flow suggests limited capacity to meet debt and dividend obligations.
• Interest coverage ratio: EBIT (earnings before interest and taxes) divided by periodic interest payments. A higher ratio indicates greater ability to cover interest expenses. A cash-based variant uses EBITDA (earnings before interest, taxes, depreciation, and amortization) divided by interest payments.
• Leverage and liquidity ratios: measures of debt loads relative to equity, assets, or cash flow help signal repayment capacity.
• Credit ratings: agencies assign ratings that classify debt as investment grade (lower default risk) or speculative/high-yield (higher default risk). Higher-rated debt generally commands lower interest rates.

Measuring an individual’s default risk

Consumers’ default risk is evaluated using credit reports and credit scores derived from information reported by lenders. Key factors include:

• Payment history: on-time payments are the most important determinant.
• Credit utilization ratio: outstanding balances divided by total available credit. Ratios above about 30% tend to hurt scores; lower is better.
• Credit history length, recent inquiries, and public records (bankruptcies, collections).

Most credit scores range from 300 to 850. For example, a FICO score above ~670 is commonly viewed as “good” and typically yields better borrowing terms than lower scores.

Consequences of default

• Secured loans: lender can repossess or foreclose on collateral (e.g., vehicle, real estate).
• Unsecured loans: lender may sue, report to credit bureaus, or assign debt to collection agencies.
• Future borrowing: default makes obtaining new credit difficult and expensive; higher interest rates or denial are common.
• Credit reporting: a default can remain on a consumer’s credit report and negatively affect scores for up to seven years.

Delinquency vs. default

• Delinquency: missing one or more scheduled payments.
• Default: occurs after a series of delinquencies as defined by the lender or loan terms. Default carries more severe legal and credit consequences than a single delinquent payment.

Bottom line

Default risk is central to lending and investing decisions. Lenders use credit histories, financial ratios, cash-flow analysis, and credit ratings to estimate default probability. Higher assessed risk leads to higher interest rates, stricter terms, or reduced access to credit. Managing cash flow, maintaining strong payment history, and controlling credit utilization are key ways borrowers can reduce perceived default risk.