Understanding Credit Risk: Definitions, Ratings, and Key Examples

What Is Credit Risk?

Credit risk is the risk a borrower poses to lenders of failing to pay back money loaned to them. Such a loan default has a negative financial impact on creditors because it halts the flow of cash to them, causing a loss. Therefore, creditors must be careful to assess the credit risk of borrowers before extending them funds. To analyze credit risk, creditors examine and compare a potential customer's income, existing debt load, and their capacity to repay a new loan. They look at any history of debt and payments made as well as collateral that may be associated with their loan, if applicable. The creditor receives interest payments at a rate they set in exchange for taking on a credit risk.

Analyzing and Managing Credit Risk

Offering loans like mortgages or credit cards comes with the risk of borrower default. Similarly, if a company offers credit to a customer, there is a risk that the customer may not pay their invoices.

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 allowed businesses to quickly analyze data used to determine a customer's risk profile.

Agencies like Moody's and Fitch rate the credit risks of corporate and municipal bonds. If an investor considers buying a bond, they will often review the credit rating of the bond. Bonds rated below BBB carry higher default risk. Stronger ratings of BBB or above indicate lower risk.

How Credit Risk Influences Interest Rates

Creditors may decline a loan to a borrower they perceive as too risky.

For instance, applicants with high credit ratings and steady income are seen as low risk and usually get low-interest rates. In contrast, an applicant with 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 those with perfect credit ratings. The issuers with lower credit ratings use high returns to entice investors to assume the risk associated with their offerings.

The Bottom Line

Credit risk represents the chance of financial loss when a borrower defaults on a loan or other financial obligation. Lenders evaluate a borrower's credit risk by examining factors such as credit history, income, debt load, and repayment history. Effective credit risk management involves employing the five Cs: capacity, capital, conditions, character, and collateral. Higher perceived credit risk leads to higher interest rates or loan denial. Strong credit ratings are vital for favorable borrowing conditions, while lower ratings increase borrowing costs. Bond investors should consider credit ratings, as lower-rated bonds offer higher returns to compensate for elevated risk.