What is Default Risk?
By the end of March 2023, the credit card defaults rose to Rs. 4,072 crores. Also, it’s worth noting that the Indian banks wrote off a staggering Rs. 10.60 lakh crores owing to defaults. But what is it, and what implications does it carry? Today, let’s understand default risk in detail and see how it can impact your creditworthiness.
Default Risk in detail
Default risk refers to the possibility that a borrower fails to meet its debt obligations by not being able to make timely payments of interest and/or principal. In simpler terms, it's the risk that someone who borrowed money may be unable to pay it back as promised.
Knowing about default risk is important for investors because it helps them understand how risky an investment might be. By considering default risk, investors assess:
- How much return can they generate?
- What are the chances of not receiving timely interest or principal?
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How is default risk determined?
Let’s gain an understanding of some popular assessment factors widely used to assess default risk:
Creditworthiness of the borrower
- The term “creditworthiness” represents the financial health and stability of the borrower.
- It shows the ability of the borrower to repay debt.
- It is assessed through a careful evaluation of:
- Income
- Assets
- Liabilities, and
- Credit history
Economic conditions
- Default risk is influenced by several economic factors, such as:
- GDP growth
- Unemployment rates
- Inflation
- Interest rates
- A downturn in the economy increases the likelihood of borrower default.
- This happens as businesses and individuals struggle to meet their financial obligations.
Debt structure and terms
- Default risk is also impacted by the structure and terms of the debt obligation, such as:
- Interest rate
- Maturity date, and
- Collateral requirements
- Usually, higher interest rates or shorter maturity periods increase the risk of default.
What is the role of credit rating agencies?
Credit rating agencies play a crucial role in determining the creditworthiness of individuals, companies, and governments. These agencies give evaluations of borrowers' ability to pay back debts by conducting valuable assessments. Some popular credit rating agencies operating in India are:
- CRISIL (Credit Rating Information Services of India Limited)
- ICRA (Investment Information and Credit Rating Agency) Limited
- CARE (Credit Analysis and Research Limited),
- Acuite Ratings and Research Limited
- Brickwork Ratings, and many more.
How to measure a company's default risk?
The default risk of corporations is determined using both qualitative and quantitative factors. Several methods are used to assess the financial health and creditworthiness of a company. Let’s have a look at three common methods:
Method I: Credit ratings
- Credit rating agencies rate corporations by assessing the likelihood of default
- Post assessment, these assign a grade based on the company's:
- Financial strength
- Industry outlook, and
- Macroeconomic factors
Method II: Financial ratio analysis
- Several key financial ratios are used to:
- Evaluate a company's financial performance and
- Assess its default risk
- Some key ratios include:
| Ratios | Meaning | Formula |
| Debt-to-equity ratio | Measures how much of a company's funding comes from debt compared to how much comes from equity. It shows how leveraged a company is. | Total Debt/Total Equity |
| Interest coverage ratio | Shows the company's ability to meet interest payments on its debt obligations using its earnings before interest and taxes (EBIT). | EBIT/Interest Expense |
| Current ratio | Compares current assets to current liabilities to assess the company's short-term liquidity position. | Current Assets/Current Liabilities |
Method III: Credit scoring models
- Some financial institutions and credit bureaus in India use credit scoring models to assess default risk.
- These models assign a numerical score based on various factors such as:
- Payment history
- Credit utilisation, and
- Debt-to-income ratio
What happens if you default on a loan?
Defaulting on a loan in India can have significant consequences, affecting both the borrower's financial well-being and creditworthiness. Here's an outline of the potential repercussions:
Legal proceedings
- When a borrower defaults on a loan, the lender initiates legal proceedings to recover the outstanding amount.
Credit score impact
- Failing to repay a loan causes significant harm to the borrower's credit rating.
- This makes it harder to obtain credit in the future
Asset Seizure
- In cases of secured loans where the borrower has pledged collateral (e.g., property or vehicles), the lender can seize the collateral to recover the outstanding debt.
How does default affect your ability to get credit in the future?
Defaulting on a loan results in a significant drop in your credit score. This negative mark remains on your credit report for several years, typically up to seven years in India. Lenders use credit scores to assess your creditworthiness and a lower score indicates higher risk. This makes it harder to qualify for loans or credit cards in the future.
Furthermore, even if you qualify for credit after defaulting on a loan, you may be offered less favourable terms, such as:
- Higher interest rates or
- Stricter repayment terms
Conclusion
Default risk represents the likelihood that the borrower will not make timely interest payments and/or repay the principal. Defaulting on a loan carries significant consequences, including legal action, credit score damage, and potential asset seizure. Also, it can severely limit future credit opportunities and lead to higher borrowing costs.
