Default rate: Overview, definition, and example
What is a default rate?
A default rate refers to the interest rate that is applied to a loan or credit agreement when the borrower fails to make payments according to the terms of the contract. The default rate is typically higher than the standard interest rate and is meant to compensate the lender for the increased risk and administrative burden caused by the borrower’s failure to pay on time. Default rates are often specified in the original agreement and may apply when a borrower misses a payment, goes past the due date, or breaches other terms of the agreement.
For example, a credit card company may apply a default rate to an outstanding balance if the cardholder fails to make the required minimum payment by the due date.
Why is a default rate important?
A default rate is important because it provides a financial deterrent against missed or late payments, encouraging borrowers to stay current on their obligations. It also helps protect lenders by compensating them for the increased risk associated with a borrower who has defaulted. For businesses that lend money or extend credit, the default rate is an essential tool for managing financial risk and recovering some of the costs incurred due to non-payment.
For borrowers, it serves as a reminder that failure to comply with payment terms can lead to significantly higher costs. It’s important for both parties to understand how default rates are triggered and how they impact the overall balance.
Understanding default rate through an example
Imagine a company that offers financing to small businesses. The company’s standard interest rate is 5%, but if a borrower misses a payment and goes into default, the company increases the interest rate to 10% (the default rate). The higher rate applies to the outstanding balance, increasing the cost for the borrower and providing compensation for the increased risk to the lender.
In another example, a borrower with a credit card may have a standard interest rate of 18%, but if they fail to make the minimum payment on time, the credit card issuer may apply a default rate of 29%, which is significantly higher.
An example of a default rate clause
Here’s how a default rate clause might look in a contract:
“If the Borrower fails to make a payment when due, the interest rate on the outstanding balance will increase to a default rate of [Insert Rate]% per annum, effective immediately upon default. The Borrower agrees to pay all accrued interest at the default rate until the account is brought current.”
Conclusion
The default rate is a key financial term used to increase the cost of borrowing in the event of non-payment, providing a deterrent against late payments while compensating the lender for the additional risk and administrative burden. For businesses that extend credit or loans, the default rate helps manage the financial risks of borrower non-compliance.
For borrowers, understanding the terms surrounding default rates is critical for avoiding higher costs and maintaining favorable payment terms.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.