How lenders calculate LGD — quick formula and steps

LGD is expressed as a percent and starts with a simple formula:

  • LGD = (Loss in value after recoveries) ÷ (Exposure at Default, or EAD)

Practical steps lenders follow when calculating LGD

  1. Measure exposure at default (EAD).
  • EAD is the total amount the borrower owes at default (outstanding principal, accrued interest, unused commitments if applicable).
  1. Estimate recoveries.
  • Recoveries include proceeds from collateral sales, guarantor payments, insurance, and collections net of legal, auction, and repossession costs.
  • Lenders may discount future recoveries to present value if recovery takes months or years.
  1. Adjust for cure and cure rates.
  • Some defaults reverse (borrower cures the delinquency). Lenders use historical cure rates to separate recoveries from true losses.
  1. Use an LGD methodology.
  • Common methods: historical realized LGD, workout LGD (case-by-case recoveries), market-implied LGD (for traded debt), and regulatory or supervisory floors.
  • Banks using internal ratings-based (IRB) approaches follow Basel Committee guidance for estimating LGD and applying supervisory LGD floors (see the Basel Committee on Banking Supervision: https://www.bis.org/bcbs/).
  1. Validate and segment.
  • Lenders segment portfolios (residential mortgages, commercial CRE, unsecured consumer loans) because LGD varies widely by product, collateral quality, geography, and economic cycle.

Example: a simple numeric illustration

  • Loan outstanding at default (EAD): $200,000
  • Net recoveries (collateral sale minus costs): $120,000
  • LGD = (200,000 − 120,000) ÷ 200,000 = 0.40 or 40%

How LGD affects pricing and interest rates

  • Expected loss (EL) per loan is PD × LGD × EAD (PD = probability of default).
  • Example: PD = 2% (0.02), LGD = 40% (0.40) → EL = 0.02 × 0.40 × EAD = 0.008 × EAD = 0.8% of EAD annually (on average).
  • Lenders cover expected loss plus operating costs, taxes, profit margin, and the cost of holding regulatory capital. That drives the risk premium over the lender’s funding or risk-free rate.
  • Capital charges (in banks) arise from regulatory frameworks such as Basel; higher LGD typically raises required capital for risky exposures, increasing the lender’s effective cost of lending (see Basel Committee guidance at https://www.bis.org/bcbs/ and Federal Reserve commentary on bank capital: https://www.federalreserve.gov/).

Real-world variation and drivers of LGD

  • Secured vs unsecured: secured loans (first mortgages) usually have much lower LGD because collateral can be sold; unsecured consumer loans often have high LGD.
  • Jurisdiction and legal process: time-to-recovery and foreclosure costs differ by state and country, changing net recoveries.
  • Collateral quality and seasoning: home prices, commercial valuations, and lien priority (first vs subordinate lien) materially affect LGD. See related discussion about lien priority in our glossary entry on Nonrecourse vs Recourse Loans: What Real Estate Borrowers Should Know.

How borrowers can reduce the LGD lenders assign

  • Offer strong collateral or higher-quality collateral to lower expected loss.
  • Provide guarantors or credit enhancements (insurance, letters of credit) to increase recoveries.
  • Shorten loan terms or amortize principal faster to reduce EAD at any point in time.
  • Keep documentation and valuation up to date; clear title and properly perfected security interests lower recovery costs (see our guide to Lending 101: Understanding Principal, Interest and Amortization).
  • Maintain good credit behavior and communication—workouts and timely cures reduce realized LGD.

Common misconceptions

  • LGD is not the same as probability of default (PD). LGD measures loss severity given default; PD measures likelihood of default. Pricing driven by expected loss combines both (EL = PD × LGD × EAD).
  • LGD is not fixed. It changes with market values, legal costs, and borrower behavior; prudent lenders re-estimate LGD through the cycle.

Brief professional note

In my 15+ years in lending strategy I’ve seen two loans with identical credit scores result in very different pricing because of LGD drivers—one had first-lien collateral with clear title (low LGD) and the other was an unsecured working‑capital facility (high LGD). That difference often explains pricing moves that credit-score–only explanations cannot.

Sources and next steps

This content is educational and not individualized legal or financial advice. For decisions about a specific loan, collateral structure, or refinancing, consult a qualified lender or financial advisor.