A Guide To Default Rates For Loans
What is a default rate
The default rate or ‘delinquency rate’ refers to the percentage of funded customers that fail to repay their loans. When a customer misses repayments and finds themselves in a position where they are unable to repay at all, their loan is moved into a state of arrears, also known as default or delinquency.
A customer that misses one repayment and then makes the next one or pays off through an arrangement or pay plan is not considered a default. This is because the loan is still open and will probably still be paid off. A default state is therefore one which lenders can practically write off because the chances of recovering their loan amount are small.
The default rate for payday loans is around 10 to 20%, depending on the lender. The default rate for guarantor loans is less than 5%.
Why is this important?
The default rate is very important because it is crucial to the lenders’ business model and determines:
- who they lend to
- how much they lend
- the rates they charge
For lenders, one of their main goals is to keep their default rate as low as possible. However, they have to lend out money as well to be profitable, so they need to find the balance between the risks involved.
Since a defaulted loan is not recovered, the margins or representative APR that lenders charge needs to reflect the risk and needs to be set a rate so they can still be profitable. It is for this reason that payday loans are considered an expensive form of short term finance, because the default rate is high, so lenders have to charge high fees to account for the potential losses.
Using the profile and demographic of defaulted customers, lenders can adjust their criteria and score card to reflect who they lend to. Using historical data, they can determine the right kind of customer for them who is less likely to default. For instance, if there is strong data to show that people from this part of the UK are prone to defaulting, the loan provider can assess this carefully moving forward. Plus, if an applicant shares some of the characteristics of a delinquent customer, they can always limit the amount they can borrow.
What do companies do to reduce their default rate?
One of the most basic things that lenders can do to limit their default rate is to have a dedicated collections team that is speaking with customers one-by-one and following up on repayment. The Financial Conduct Authority have strict guidelines in terms of how firms can approach those in arrears or awaiting repayment and this includes the type of language and number of times they can be contact through phone, email, SMS and post. Lenders can also use technology to stay on top of their collections via automated follow-ups and using data to analyse the best ways to collect from customers. Perhaps they can understand that some debtors may be able to pay off certain amounts more than others, and an efficient lender will be able to assess this.
By adding security to a product and putting something down as collateral can certainly lower the default rate. Firstly, the lender is able to recuperate their funds through the security whether it is reselling the car, house or jewellery at market value. There is also having a guarantor as security to back-up your loan, which is why the default rate is lower than a payday loan. Secondly, secured products typically offer lower rates because of that security in the background. This could mean lower monthly payments for some products, making them easier to manage and hence a lower default rate.
Lenders can also sell the debt of a delinquent customer to recover any lost funds. There are professional debt management companies that will pay for a lead and help the customer pay off their debts, little by little, and charge a fee in the process. There are also free debt management companies and charities like StepChange who can help.
Finally, loan companies can always be more selective with who they lend to. Of course, this is not easy given that they want to lend out funds because this is how lenders generate revenue. But being stricter with their criteria such as the minimum age they lend to, credit score and monthly income can certainly isolate the customers that are more likely to repay successfully.
Why does it matter if I default my loan?
You may be thinking, does it matter if I don’t pay back my loan? The answer is yes. When your loan falls into arrears, not only are there additional fees like the daily interest and default fee added to your loan, it also negatively impacts your credit score. A note is added to your credit file saying that your loan is in a delinquent state and stays on there for up to 6 years.
When you apply for future credit products including loans, credit cards and mortgages, the vendors will be able to see that you have defaulted on a loan and this may drastically impact the chances of your loan being accepted. Furthermore, it may limit the amount you wish to borrow and for those with bad credit, you may be very restricted in the type of finance and pay much higher rates for the privilege of borrowing.
Therefore, it is in your best interests to repay your loan and on time, because contrarily, this will cause your credit score to improve, giving you better rates of finance in the future and a higher chance of approval. If you are having trouble repaying your loan, you can always speak to the lender to help with spreading the payments over a longer period of time, this will not have such a negative impact on your credit rating for future purpose.