What is a credit risk?
Credit risk is a measure of the creditworthiness of a borrower. In calculating credit risk, lenders are gauging the likelihood they will recover all of their principal and interest when making a loan. Borrowers considered to be a low credit risk are charged lower interest rates. Lenders, investors, and other counterparties consult ratings agencies to asses the credit risk of doing business with companies.
When determining the credit risk involved in making loans, lenders are judging borrowers’ ability to pay back debt. A range of factors go into assessments of credit risk, including credit history and credit score, debt-to-income ratio, and collateral.
- Credit history and credit score: Independent credit bureaus maintain records of borrowers’ credit payment history, total debt load, and types of credit taken out to generate credit scores. They sell this data to financial institutions to help them assess credit risks.
- Total debt load: This measures how much existing credit has been extended to a borrower and how much of that credit she has already utilized. The less credit a borrower has used, the more able they should be to pay back a new loan. Creditors like to see how easily a borrower can get credit and judiciously they balance it.
- Debt-to-income ratio: This compares the amount a person makes against their living expenses and debt payments. Lenders use it to decide if a borrower can afford to take on a new debt payment.
- Collateral: This is the assets owned by a borrower that can be used to secure a loan. The more collateral a borrower has, the lower the possible credit risk for a lender.
For companies, credit risk represents the risk that a company may not be able to make payments on its outstanding debt. Ratings agencies — Moody’s and Standard & Poor’s, for example — analyze bond offerings and issue credit ratings that grade the credit risk of different debt instruments.
It’s possible to give your creditworthiness a facelift by reviewing your credit report for any mistakes, paying down credit card debt, making all payments on time and cutting expenses wherever possible.
Check out Bankrate’s debt-to-income ratio calculator to see how much credit you can afford.
Credit risk example
Ignoring credit risks was the major animating factor behind the financial crisis of 2007-2008. In the years leading up to the crisis, banks and other lenders lent vast sums in the form of subprime mortgages to high-risk borrowers. As the economy slowed in 2006-2007, many of these risky borrowers couldn’t repay their loans, and the turbulence from this systemic failure to properly account for credit risk nearly wrecked the global financial system in late 2008. Major banks suffered losses because the models they used incorrectly assessed the likelihood of default on mortgage payments.