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What is 'Credit Risk'

Credit risk is the probable risk of loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Although it is impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of loss. 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 mortgages, credit cards, or other types of loans, there is a 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 will be unable to pay a claim.

Assessing Credit Risk

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:  credit history, capacity to repay, capital, the loan's conditions and associated collateral.

Some companies have established departments solely responsible for assessing the credit risks of its current and potential customers.  Technology has afforded businesses the ability to quickly analyze data used to assess a customer's risk profile.

For investments, if an investor considers buying a bond, he/she will often review the credit rating of the bond. If it has a low rating, the issuer has a high risk of default. Conversely, if it has a high rating, it is considered to be a safe investment. Bond credit-rating agencies, such as Moody's and Fitch, evaluate the credit risks of thousands of corporate bond issuers and municipalities continuously.

For example, a risk-averse investor may opt to buy a AAA-rated municipal bond. In contrast, a risk-seeking investor may buy a bond with a lower rating in exchange for potentially higher earnings.

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 or they may forgo the investment or loan. For example, because a mortgage applicant with a superior credit rating and steady income is likely to be perceived as a low credit risk, he will receive a low-interest rate on his mortgage. In contrast, if an applicant has a poor 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, to obtain financing.

Similarly, bond issuers with less than perfect ratings offer higher interest rates than bond issuers with perfect credit ratings. The issuers with lower credit ratings use high returns to entice investors to assume the risk associated with their offerings.

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