What Is Credit Risk?
Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a loan. Essentially, credit risk 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. Lenders can mitigate credit risk by analyzing factors about a borrower's creditworthiness, such as their current debt load and income.
Although it's impossible to know exactly who will default on obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.
- Credit risk is the potential for a lender to lose money when they provide funds to a borrower.
- Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
- Consumers who are higher credit risks are charged higher interest rates on loans.
- Your credit score is one indicator that lenders use to asses how likely you are to default.
Understanding 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 a customer, there is a risk that the customer may not pay their invoices.
Credit risk can describe 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.
Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original terms. To assess credit risk on a consumer loan, lenders often look at the five Cs of credit: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
Some companies have established departments responsible for assessing the credit risks of their current and potential customers. Technology has afforded businesses the ability to quickly analyze data used to assess a customer's risk profile.
Bond credit-rating agencies, such as Moody's Investors Services and Fitch Ratings, evaluate the credit risks of corporate bond issuers and municipalities and then rate them. If an investor considers buying a bond, they will often review the credit rating of the bond. If a bond has a low rating (< BBB), the issuer has a relatively high risk of default. Conversely, if it has a stronger rating (BBB, A, AA, or AAA), the risk of default is lower.
Credit Risk vs. Interest Rates
If there is a higher level of perceived credit risk, investors and lenders usually charge a higher interest rate.
Creditors may decline a loan to a borrower they perceive as too risky.
For example, a mortgage applicant with a superior credit rating and steady income is likely to be perceived as a low credit risk, so they will likely receive a low-interest rate on their mortgage. In contrast, an applicant who has a poor credit history, may have to work with a subprime lender to get financing.
The best way for a high-risk borrower to get lower interest rates is to improve their credit score. If you have poor credit, consider working with a credit repair company.
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.
How Do Banks Manage Credit Risk?
Banks can manage credit risk with a number of strategies. They can set specific standards for lending, including requiring a certain credit score from borrowers. Then, they can regularly monitor their loan portfolios, assess any changes in borrowers' credit worthiness and then make any adjustments.
What Are the Five Cs of Credit?
The five Cs of credit include: capacity, capital, conditions, character, and collateral. These are the factors that lender can analyze about a borrower to help reduce credit risk. Performing an analysis based on these factors can help a lender predict the likelihood that a borrower will default on a loan.
How Do Lenders Measure the Five Cs of Credit?
Each lender will measure the five Cs of credit (capacity, capital, conditions, character, and collateral) differently. Generally, lenders place a high emphasis on a potential creditor's capacity, or the amount of income they have relative to the debt they are carrying.
The Bottom Line
Credit risk is a lender's potential for financial loss to a creditor, or the risk that the creditor will default on a loan. Lenders take several factors into account when they assess a borrower's risk, including their income, debt, and repayment history. When a lender sees you as a greater credit risk, they are less likely to approve you for a loan and more likely to charge you higher interest rates if you do get approved.