How to Calculate the Value of a Defaulted Loan

The value of a loan drops when the borrower defaults on payments.

Lenders decide whether to approve a loan based on the creditworthiness of the borrower, the size of the loan, the borrower's income and the collateral assets securing the loan. However, if a borrower defaults, the lender must reassess the value of the loan. Although valuation methods vary depending on the type of loan and the lending institution, the loss in the event of default formula, also known as LIED, provides a ballpark figure lenders use to estimate the new value of a defaulted loan.

Instructions

1. Take the dollar amount of the write-offs or amortizations made after the loan defaulted. Add this figure to the loan's interest drag--the amount of interest you have lost based on the loss of interest payments based on the loan's present value.

2. Deduct the present value of the loan up to the date of the default. Subtract any unexpected payments toward the loan principal. Take away any expenses related to the loan default, such as legal and administration expenses.

3. Divide the result of Step 2 by the initial dollar amount for the default. This is the estimated loan loss ratio for the defaulted loan. If you want the ratio as a percentage of the loan amount before the default, multiply by 100. For example, a loan in default has a car in collateral worth $50,000, has $1,000 in interest drag, a present value of $100,000, no unanticipated payments toward the principal recovery and $500 in additional expenses. The loan has an estimated loan loss ratio of 0.5, or 50 percent.

4. Multiply the loan principal at the date of default by the loan loss ratio. This is the estimated loss on the defaulted loan. For example, a $100,000 loan with a loan loss ratio of 0.5 will lose approximately $50,000.

5. Deduct the estimated loss on the defaulted loan from the value of the loan at default. For instance, a $100,000 loan with an estimated loan loss of $50,000 would have a new estimated value of $50,000.

References

• Risk Worx: Recovery Rates
• Penn State University: What Do We Know About Loss Given Default?

Resources

• Thomas Ho: Valuing Fixed Rate Mortgage Loans With Defualt Prepayment Options