What Is Credit Risk?
Credit risk is the possibility of a 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. Excess cash flows may be written to provide additional cover for credit risk. 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 possibility of losing a lender takes on due to the possibility of a borrower not paying back a loan.
- Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
- Consumers posing higher credit risks usually end up paying higher interest rates on loans.
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 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.
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 look at the five Cs: 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 their current and potential customers. Technology has afforded businesses the ability to quickly analyze data used to assess a customer's risk profile.
If an investor considers buying a bond, they will often review the credit rating of the bond. If it has a low rating (B or C), the issuer has a high risk of default. Conversely, if it has a high rating (AAA, AA, or A), it's considered to be a safe investment.
Bond credit-rating agencies, such as Moody's Investors Services and Fitch Ratings, evaluate the credit risks of thousands of corporate bond issuers and municipalities on an ongoing basis. For example, a risk-averse investor may opt to buy an AAA-rated municipal bond. In contrast, a risk-seeking investor may buy a bond with a lower rating in exchange for potentially higher returns.
Credit Risk vs. Interest Rates
If there is a higher level of perceived credit risk, investors and lenders usually demand a higher rate of interest for their capital.
Creditors may also choose to 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 low credit risk, she will receive a low-interest rate on her 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.