Credit risk is a form of financial risk in which there is a risk that a borrower will fail to make the required payments. The required payments can potentially refer to both owed principal and interest. Should the borrower be unwilling or unable to make repayments the loan is considered in default. Credit risk can take any form of loan or debt, including mortgages.
The consumer credit risk is calculated by a number of different factors. This includes credit history, associated collateral, capacity to repay, and the conditions of the loan. This is sometimes called the five C’s.
Credit risk analysis is key to lenders and financial organizations to avoid losses and maximize yields. Many banks and lenders have departments dedicated to calculating this risk by performing credit checks. After the risk is calculated, a credit score is usually given which grades the credit risk. This is usually graded in letters such as BBB, A, AA, and AAA from lowest ranked to highest.
Interest rates and credit risk are inherently linked. As credit risk decreases, a better credit score is issued which tends to lead to more favourable interest rates in a loan.
Individuals with good credit scores are more likely to get a loan approved and usually at lower rates. Individuals with bad credit scores, may not get a loan application approved and may have to turn to high-interest lenders to receive financing.
Credit scores can be improved over time to allow formerly high-risk borrowers to receive better rates.