Default risk refers to the risk that a borrower will not be able to repay a loan as agreed, leading to a default on the loan. Lenders charge a premium for taking on default risk, which is reflected in the interest rate they charge on loans.
The relationship between default risk and interest rates is straightforward: as the default risk of a borrower increases, the interest rate charged by lenders also increases. This is because lenders require compensation for the additional risk they are taking on by lending to a borrower who is more likely to default on the loan.
For example, if a borrower has a history of late payments, missed payments, or a low credit score, lenders may view them as having a higher default risk. As a result, lenders may require a higher interest rate to compensate for the additional risk they are taking on by lending to this borrower. On the other hand, if a borrower has a strong credit history and financial standing, lenders may view them as having a lower default risk and offer a lower interest rate.
In general, the higher the default risk, the higher the interest rate charged by lenders. This is because lenders want to be compensated for the additional risk they are taking on by lending to a borrower with a higher likelihood of default. Conversely, lower default risk typically translates to lower interest rates, as lenders are more confident in the borrower's ability to repay the loan as agreed.
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