The default premium is a financial tool that is sometimes used by lenders to help minimize the degree of risk associated with extending loans and other forms of financial support to entities with less than perfect credit ratings. This type of premium can also be utilized by businesses that are undergoing difficult financial periods in order to attract investors to their bond issues, and thus generate cash to help them move through the period and return to profitability. In both cases, the debtor is providing an additional incentive that helps make the prospect of moving forward with the deal more attractive for all parties involved.
As applied to the individual seeking a loan or a line of credit, the default premium sometimes manifests as either a higher up-front payment or a higher rate of interest that applies to the entire life of the loan. For example, if an individual with poor credit is seeking a mortgage, some lenders may be willing to take a chance in spite of the past credit history. In order to be approved, the borrower may have to produce a higher down payment on the property, and possibly agree to a higher rate of interest applied to the loan itself. These measures reduce the risk to the lender, because even if the borrower defaults during the first year of the mortgage, the value of the property will be sufficient to recoup the total investment by the lender.
For companies that are operating with less than optimum credit ratings and financial situations, the creation and issuance of a bond issue that includes a default premium is often a means of generating revenue. The revenue from the bond issue can then be used to make changes that ultimately reverse the fortunes of the business, and return it to a profitable state. Since investors are likely to be put off by the increased risk associated with the bond issue, the company may offer a higher yield on the lower grade bond issue. This helps to offset the risk to the investor, especially if the return on the bond is paid at specific points during the life of the bond, and not at the point of maturity.
It is important to note that the presence of a default premium does not completely erase the possibility of default. It does provide the investor or lender with a greater degree of protection in the event that default does actually occur. Assuming that the business deal does go well, and the debtor does successfully pay off the loan or bond issue according to terms, investors will be more open to working with the individual or business again in the future. There is also an increased possibility that the next deal can be crafted without the need to incorporate some type of default premium into the terms and conditions.
