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What is 'Credit Risk'

Credit risk refers to the risk that a borrower may not repay a loan and that the lender may lose the principal of the loan or the interest associated with it. Credit risk arises because borrowers expect to use future cash flows to pay current debts; it's almost never possible to ensure that borrowers will definitely have the funds to repay their debts. Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.

BREAKING DOWN 'Credit Risk'

When lenders offer borrowers mortgages, credit cards or other types of loans, there is always an element of risk that the borrower may not repay the loan. Similarly, if a company offers credit to its client, there is a risk that its clients may not pay their invoices. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company won't be able to make a claim.

How Is Credit Risk Assessed?

Credit risks are calculated based on the borrowers' overall ability to repay. To assess credit risk on a consumer loan, lenders look at the five C's: an applicant's credit history, his capacity to repay, his capital, the loan's conditions and associated collateral.

Similarly, if an investor is thinking about buying a bond, he looks at the credit rating of the bond. If it has a low rating, the company or government issuing it has a high risk of default. Conversely, if it has a high rating, it is considered to be a safe investment. Agencies such as Moody's and Fitch evaluate the credit risks of thousands of corporate bond issuers and municipalities on an ongoing basis.

For example, if an investor wants to limit his exposure to credit risk, he may opt to buy a municipal bond with a AAA rating. In contrast, if he doesn't mind a bit of risk, he may buy a bond with a lower rating in exchange for the potential of earning more interest.

How Does Credit Risk Affect Interest Rates?

If there is a higher level of perceived credit risk, investors and lenders demand a higher rate of interest for their capital. For example, if a mortgage applicant has a stellar credit rating and a steady income flow from a stable job, he is likely to be perceived as a low credit risk and will receive a low interest rate on his mortgage. In contrast, if an applicant has a lackluster credit history, he may have to work with a subprime lender, a mortgage lender that offers loans with relatively high interest rates to high-risk borrowers.

Similarly, bond issuers with less than perfect ratings offer higher interest rates than bond issuers with perfect credit ratings. The issuers with lower credit scores need to use high returns to entice investors to take a risk on their bonds

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