Default Premium

Default Premium

A default premium is an additional amount that a borrower must pay to compensate a lender for assuming default risk. Also, companies with lower grade (i.e., junk or non-investment-grade) bonds and individuals with low credit pay default premiums. Payday loans are often a predatory loan with extremely high-interest rates and fees. A default premium is an additional amount that a borrower must pay to compensate a lender for assuming default risk. A payday loan is a short-term borrowing solution in which a lender will extend a very high-interest credit, based on a borrower’s income and credit profile. This is a form of default premium given that lenders believe these individuals have a higher risk of being unable to repay their debts.

Payday loans are often a predatory loan with extremely high-interest rates and fees.

What Is Default Premium?

A default premium is an additional amount that a borrower must pay to compensate a lender for assuming default risk. All companies or borrowers indirectly pay a default premium, though the rate at which they must repay the obligation varies.

Payday loans are often a predatory loan with extremely high-interest rates and fees.
Companies with poor credit pay default premiums as a result.
Lenders seek default premiums for assuring default risk.

How Default Premium Works

Typically the only borrower in the United States that would not pay a default premium would be the U.S. government. However, in tumultuous times, even the U.S. Treasury has had to offer higher yields to borrow. Also, companies with lower grade (i.e., junk or non-investment-grade) bonds and individuals with low credit pay default premiums.

Corporate bonds receive ratings from significant agencies, such as Moody’s, S&P, and Fitch. These ratings are based on the revenues the issuers can generate to meet principal and interest payments, along with any assets (equipment or financial assets) they can pledge to secure the bond(s). The higher the credit rating, the lower a company’s default premium. For higher-rated issuances, investors will not receive as high of a yield.

The more revenue a company can generate, or safety it can provide, the higher its credit rating will be.

Investors often measure the default premium as the yield on an issuance over and above a government bond yield of similar coupon and maturity. For example, if a company issues a 10-year bond, an investor can compare this to a U.S. Treasury bond of a 10-year maturity.

Default Premium and Individual Credit Scores

Individuals with poor credit must pay higher interest rates to borrow money from the bank. This is a form of default premium given that lenders believe these individuals have a higher risk of being unable to repay their debts. There can be a significant amount of discrimination in the individual lending market, as evidenced by payday loans.

Special Considerations

A payday loan is a short-term borrowing solution in which a lender will extend a very high-interest credit, based on a borrower’s income and credit profile. Factors that comprise an individual credit score include the history of repaying debts, including completion and timeliness, the size of the debts, number of debts, and possibly additional information such as employment history.

Many payday lenders will set up businesses in more impoverished neighborhoods with populations that are already vulnerable to financial shocks. Although the federal Truth in Lending Act does require payday lenders to disclose their often outsized finance charges, many borrowers overlook the costs since they need funds quickly. Most loans are for 30 days or less, with amounts usually from $100 to $1,500. Often, these loans can be rolled over for even further finance charges. Many borrowers are often repeat customers.

Related terms:

Accounting

Accounting is the process of recording, summarizing, analyzing, and reporting financial transactions of a business to oversight agencies, regulators, and the IRS. read more

Bond : Understanding What a Bond Is

A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. read more

Corporate Credit Rating

A corporate credit rating is an opinion of an independent agency regarding the likelihood that a corporation will fully meet its financial obligations. read more

Credit Analyst

A credit analyst is a financial professional who assesses the creditworthiness of individuals, companies, or securities.  read more

Credit Rating

A credit rating is an assessment of the creditworthiness of a borrower—in general terms or with respect to a particular debt or financial obligation. read more

Debt Issue

A debt issue is a financial obligation that allows the issuer to raise funds by promising to repay the lender at a certain point in the future. read more

Default Risk

Default risk is the event in which companies or individuals will be unable to make the required payments on their debt obligations. read more

Negative Watch

Negative watch is a status indicating that a credit-rating agency may lower a company's rating in the near future. read more

Truth in Lending Act (TILA)

The Truth in Lending Act (TILA) is a federal law enacted in 1968 to help protect consumers in their dealings with lenders and creditors. read more

Treasury Bond (T-Bond)

A treasury bond is a marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years and which pays periodic interest payments. read more