DEFAULT PROBABILITY

The degree of likelihood that the borrower of a loan or debt will not be able to make the necessary scheduled repayments. Should the borrower be unable to pay, they are then said to be in default of the debt, at which point the lenders of the debt have legal avenues to attempt obtaining at least partial repayment. Generally speaking, the higher the default probability a lender estimates a borrower to have, the higher the interest rate the lender will charge the borrower (as compensation for bearing higher default risk).

Most people encounter the concept of default probability when they go through the process of purchasing a residence. When a home buyer obtains a mortgage on a piece of real estate, the lending bank makes an assessment of the buyer's default risk and estimates their default probability. The higher this estimated probability, the greater the interest rate applied to the loan.

The same logic comes into play when investors buy and sell fixed-income securities on the open market. Companies that are cash-flush and have a low default probability will be able to issue debt at lower interest rates. Investors trading their bonds on the open market will price safer debt with a bit of a premium compared to riskier debt. If a company's financial health worsens over time, investors in the bond market will adjust to the increased risk and trade its bonds at lower prices.