How to Calculate Default Probability

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Determine if your borrower is in over his head.
Determine if your borrower is in over his head. (Image: Dennis Sabo/iStock/Getty Images)

Default probability most often refers to the likelihood that a borrower will fail to repay a debt according to the terms of the loan contract. The underlying idea is that a certain performance is required according to an agreement with time constraints. The calculation quantifies the probability of the performing party failing to fulfill the contractual obligation. The default probability calculation is an important risk assessment tool, often performed by large financial institutions specializing in quantifying risk for wholesale lenders and quasi-governmental institutions, such as The International Monetary Fund.

Using a Default Probability Calculation

The actual calculation is not something an individual lending to another individual is likely to have the resources to execute. Fortunately, you do not need to perform the calculation yourself to benefit from the determination. A borrower's credit score is a well-known instance of a determination of default probability that you can access for either a relatively modest fee or at no cost, providing that the other party gives you permission to access the information. The process is outlined by Experian, one of three major credit-scoring agencies, in their online form "Register to Check Your Customer's Credit." Other firms provide more detailed default probability calculations at higher costs.

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