Defining Credit Risk and How to Avoid Being Labeled As One

Defining Credit Risk and How to Avoid Being Labeled As One

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“Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do,” as defined by Wikipedia. Investopedia defines it as “the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. A Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt.” In short, “credit risk” is the possibility that the borrower will actually be unable to pay the loan he has taken.

Lenders are wary of borrowers who are high credit risks because of course they would not want the borrowers to default on the loans they have made. They prefer that the people who take loans from their company are able to pay on time, and for the full amount of the monthly or quarterly amortization of what they owe. Doing so ensures that the loan will be paid on time, in full. Being paid in full would ensure that the lending company makes a profit from the loan, which then allows them to continue their business. More than that, being able to pay on time, within the reasonable pace set for the loan’s terms, is also a boon for the borrower: being able to pay in full, on time, means that the loan will remain a loan and not turn into debt.

A “loan” stays strictly a “loan” when it can be paid on time and it will eventually be paid in full. A “loan” becomes a “debt” when it becomes unmanageable. When it has not been paid in full by its due date, and when the interest has caused the loan to balloon to unmanageable proportions, that is the moment when a “loan” becomes a “debt.”

The ways to avoid credit risks for lenders are as follows:

The borrower’s credit history and credit score are primary considerations – Looking into the borrower’s credit report will give the lender an idea how the borrower handles loans and debts. A history of defaults plus a low credit score will mean that the borrower is not worth taking a risk on being given a loan. Not only that, a low credit score or being in bad credit is already a red flag for the lender: being in bad credit means that the borrower probably has a history with defaulting on debts, and will be a bad investment for the lending company.

The lenders need to calculate the debt-to-income ratio – This means that if the borrower already has a lot of debt, and shouldn’t really be taking on more debt, they shouldn’t take a risk on the borrower.

The lender has to evaluate the borrower’s Income vs. Expenses – The creditors need to take a look at how the borrower is handling his income, and whether his income can actually handle his expenses. If his expenses tally up to more than his income, it’s not a good idea to let the borrower take on a fresh loan.

The presence of collateral may minimize the credit risk for the lenders – If the borrower has collateral to exchange for the loan that is more than the value of the loan amount, then this is also something to consider for the lending company. If it were a no-collateral loan and the borrower has nothing of value to the lending company, then the credit risk that the lenders are taking on may not be worth it. But if there is collateral that may be equal to or greater than the loan amount, then this could be a positive point for the borrower.

If you’ve seen your credit standing pushed down to bad credit because of credit fraud, then you may want to find ways to get your credit back in good standing. Since your bad credit has been affected by things beyond your control anyway, then you can dispute the transactions that were recorded in your accounts because of credit fraud.

As a consumer, the basic thing to do in order to find ways to avoid being a credit risk basically boils down to getting your income to a state that it is higher than your expenses, or bring down your expenses to the level that fits your income. This will give you the margin needed to take on a loan and help ensure a lender that you will not default on it.

When it comes to credit myth risks are aware that the three credit unions will score you on different scales, but one thing is for sure: They will work on showing, via your credit report, whether you are credit worthy or not. If you live a life where your income is greater than your expenses, or your expenses are less than your income—plus your debts are either nonexistent or are all within manageable levels— know that your credit risk will be within levels that will satisfy your potential lenders. Always bear in mind that lending is an investment: lenders will loan you money if and when they know that you can pay it all back.

Amy Johnson is an active blogger who is fond of sharing interesting finance related articles to encourage people to manage and protect their finances. She also covers topics on credit monitoring and credit protection that can help people prevent themselves from identity theft & credit fraud.

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