What is credit risk?
What is credit risk and how does it work? Looking for a simple credit risk definition? We’ve got you covered.
What is credit risk?
The credit risk definition is as follows: credit risk is an assessment of the likelihood that a borrower, whether a company or an individual, might not be able to pay back the money loaned. However, it's not only people that have credit risk: investments, such as bonds, also bear it.
The credit risk tells investors how risky it is to invest in any particular asset. The higher the risk, the higher the chances of losing money on the investment, and vice-versa. When you get a loan, your credit risk is calculated, but when you are thinking of investing, you need to calculate the credit risk of the investment itself.
In simpler terms, credit risk meaning is that of a measure of the creditworthiness of a borrower. Although it's almost impossible to predict which side of the contract may default on obligations, properly assessing and managing credit risk can lessen the severity of a loss. Interest payments from the borrower of a debt obligation are a lender's reward for assuming credit risk.
In calculating credit risk, lenders are gauging the likelihood that they will recover all of their interest and principal when giving a loan. Lenders, investors and other counterparties usually consult various rating agencies to estimate the credit risk. Borrowers that are considered to be a low credit risk are usually charged lower interest rates.
Where have you heard about credit risk?
If you take out a loan, your lender will have to figure out what kind of a credit risk you are. You may also see advertisements from companies like Experian and Equifax, suggesting you check your credit score, which is a number that represents your personal creditworthiness.
What you need to know about credit risk...
Lenders make judgements about how likely borrowers will be able to afford repayments out of their future income. When deciding whether or not to lend, they will weigh up things like whether you have paid back other loans in the past, the terms of the loan and any security they will get against the loan. The idea of credit risk doesn't only apply to individuals wanting to borrow money but to companies and governments too.
If you are buying a bond, you are lending money to a company or a government. When you consider the price you are willing to pay for that bond, you have to understand how likely it will be that you are paid the interest promised and that the value of the bond will be redeemed in full at the end of the term.
Credit risks are calculated based on the borrower's overall ability to pay back debt according to its original terms. To evaluate credit risk, lenders typically look at several factors, such as the borrower's credit history, capital, debt-to-income ratio, the loan's conditions and associated collateral.
When it comes to bond investments, some of the main factors that can influence an issuer's credit risk are poor or falling cash flow from operations, rising interest rates, any regulatory changes, an increase in competition, or changes in the nature of the market that adversely affect the issuer, such as technological changes.
Complex programs and significant resources are used to analyse and manage risk. Some companies have established entire departments that are solely responsible for assessing the credit risks of their current and potential clients. The development of technology has improved businesses’ ability to quickly analyse data used to estimate a customer's risk profile.