The default rate is a calculation that includes all loans issued by a lender that have been written off as unpaid by the borrower and are officially in default. Loans typically go into default after an extended period of missed payments, and they are considered to be in violation of the terms of the loan agreement.
Key takeaways:
- The default rate can be used to help evaluate and manage risk with loans issued by a lender.
- It can represent a higher interest rate that acts as a penalty for borrowers who have missed loan payments This is commonly referred to as the penalty rate, which is used to prevent further losses and can be implemented and reduced per the lender’s preference. .
- Default rates across various types of debt can be used as an indicator of economic health.
Default rate formula
The following formula represents how the default rate is calculated:
| Default rate | = | Number of defaulted loans | × | 100 |
| Total number of loans |
Default rate example
For a sample of how the above default rate formula is used, let’s say a lending institution has 15 defaulted loans and 600 total loans. To calculate the lender’s default rate, divide the 15 defaulted loans by the 600 total loans and then multiply that value by 100.
(15 ÷ 600) × 100 = 2.5
In this scenario, the resulting default rate is 2.5%.
Why the default rate matters
The default rate helps lenders or financial institutions manage and analyze risk associated with their loan portfolios. Essentially, it acts as an indicator of the likelihood of borrowers failing to make payments on their loans, which directly affects the lender’s financial position and well-being.
If a lending institution finds that it has a high default rate, it should take a closer look at its lending portfolio and review its lending procedures. In this case, the higher the default rate, the higher the risk associated with lending to borrowers. The risk of major losses can be mitigated by lenders who act to lower their loan default rate and protect themselves from lending transactions and borrowers that may be considered high risk.
How a loan goes into default and what happens after it does
Loans typically enter into default after an extended period of missed payments, typically 270 days or more. A borrower who defaults on their loan is likely to see an impact on their business credit score since lenders may report any delinquencies and may be especially affected in the event of default. This may also impact a borrower’s ability to obtain financing in the future.
It’s common for a lender to transfer the defaulted account to a third-party debt collection agency to recoup losses. If payments cannot be collected, the lender writes them off as a loss and removes them from its books.
Causes of loan default and high default rates
High default rates are incurred if borrowers are commonly entering into default with their loans. Borrowers are responsible for making timely payments in accordance with the terms and conditions of their financing agreement. If they have a delinquent loan and enter into default, the risk of the lender taking a loss increases greatly.
Below are some common examples of how loan default may take place, which can ultimately impact default rates.
Cause of default | Sample | What it is |
|---|---|---|
Lack of creditworthiness and risky borrowers | Poor credit history | Borrowers with past defaults or low credit scores are more likely to default again. |
Lack of financial literacy | Misunderstanding loan terms or risks can lead to repayment issues. | |
Fraud and misuse of funds | Misrepresenting finances or misusing loans increases default risks. | |
Poor financial management | Overleveraging | Borrowing beyond one’s ability to repay leads to financial distress. |
Inadequate cash flow | Inconsistent or negative cash flow makes timely debt payments difficult. | |
Lack of savings or emergency funds | Unexpected expenses cause financial strain and increase default likelihood. | |
High interest rates and unfavorable loan terms | Rising interest rates | Increased borrowing costs make loans harder to repay. |
Predatory lending practices | Hidden fees or unreasonable terms can lead to defaults. | |
Short loan terms | Large repayment obligations in a short period can be unsustainable. | |
Economic factors | Recession or economic downturns | Slower economic activity reduces income and ability to repay debts. |
High inflation | Rising costs strain finances, making debt payments harder. | |
Unemployment | Job losses reduce personal and business income, increasing default risk. | |
Business and industry challenges | Market changes and competition | Businesses failing to adapt may lose revenue and default on loans. |
Supply chain disruptions | Delays in goods and services impact revenue and cash flow. | |
Seasonal fluctuations | Industries with seasonal income struggle with consistent loan repayments. | |
External crises and unforeseen events | Natural disasters | Hurricanes, floods, or fires can disrupt finances and repayment ability. |
Political and regulatory changes | New laws or restrictions can impact business profitability and cash flow. | |
Pandemics and health crises | Unexpected crises (e.g., COVID-19) cause widespread financial struggles. |
How to prevent high default rates
Common actions a lender can take include the following:
Frequently asked questions (FAQs)
The default rate is the percentage of loans that a lender has written off of its books based on lending transactions that are considered to be uncollectable.
A default interest rate is a higher rate of interest applied to a loan if a borrower misses payments. It is typically applied as a penalty for not making payments in a timely manner and allows the lender to make up some of its losses and further mitigate risk.
To calculate the default rate, the formula is to divide the total number of loans in default by the total number of loans, and then multiply that quotient by 100.
What constitutes a good default rate can vary widely based on the type of debt involved. That said, the lower the default rate, the better, as it represents fewer events of loan default and an overall better financial position for a lender.
Bottom line
Knowing what the default rate is and what it means can help you understand the risks associated with issuing financing and why financial institutions may have certain qualification requirements or stipulations involved when seeking financing.
