Loading the player...

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

RELATED TERMS
  1. Credit Rating

    A credit rating is an assessment of the creditworthiness of a ...
  2. Credit Analyst

    A financial professional who has expertise in evaluating the ...
  3. Credit Score

    A credit score is a number ranging from 300-850 that depicts ...
  4. Credit Event

    A credit event is any sudden and negative change in a borrower's ...
  5. Bad Credit

    A qualification of an individual's credit history that indicates ...
  6. Credit Analysis

    Credit analysis is a type of analysis an investor or bond portfolio ...
Related Articles
  1. Personal Finance

    Purchasing a Home with Bad Credit Is Possible: Here's How

    A bad credit report can become an obstacle, resulting in denials for credit or higher interest rates, but borrowers with low credit scores can still purchase a home.
  2. Personal Finance

    How To Overcome Bad Credit

    Some lenders can look overlook your credit score and assess other factors that fairly determine if you are a reasonable credit risk.
  3. Personal Finance

    Credit score ranges: What do they mean?

    Take a closer look at what credit scores in each range mean for your financial future. Learn how to improve your credit score and how it affects your interest and ability to borrow money.
  4. Personal Finance

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  5. Personal Finance

    Bad Credit? You Can Still Get a Home Equity Loan

    If your credit history is less than stellar and you need cash, you may be able to get financing – but it will come at a price.
  6. Investing

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  7. Tech

    Good Credit? Try This Credit Card Alternative

    Personal loans are a credit card alternative to try if you've got great credit and you want to lock in a lower interest rate on what you borrow. [underlined word is credit card alternative]
  8. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
  9. Personal Finance

    Trended Credit Data Could Increase Interest Rates for Borrowers (FNMA, EFX)

    Mortgage lenders will soon be required to use trended credit data to qualify borrowers. As a result, many borrowers could have to take higher interest rates.
  10. Personal Finance

    Home Improvement Loans: What Are Your Best Options?

    If you plan on taking out a home improvement loan, you should know what your options are and which ones might be best for your situation.
RELATED FAQS
  1. How important is credit rating on a fixed income security?

    Learn how credit ratings for fixed-income securities impact the yield and provide guidance for the amount of risk for the ... Read Answer >>
  2. Understanding the Five Cs of Credit?

    Learn how the five C's of credit affect new credit application decisions, and understand how a lender analyzes each aspect ... Read Answer >>
  3. What is the difference between a loan and a line of credit?

    Understand how to differentiate between lines of credit and standard loans. Then determine when you are most likely to use ... Read Answer >>
Hot Definitions
  1. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  2. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  3. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  4. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  5. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  6. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
Trading Center