Credit Risk

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. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.

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.

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 (< 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 progressively diminished.

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 a low credit risk, they will receive a low-interest rate on their mortgage. In contrast, if an applicant has a poor credit history, they 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. The best way for a high-risk borrower to acquire lower interest rates is to improve their credit score; those struggling to do so might want to consider working with one of the best credit repair companies.

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.