What is credit risk?
March 22, 2021
Credit risk is the risk lenders take when they offer you credit. When creditors lend money, they’re taking a risk of loss—the borrower either will or will not pay them back. Deciding whether or not to lend to a person is known as credit risk management.
Ideally, you’ll be seen as a low credit risk. If you’re a high credit risk, there are steps you can take to improve how lenders see you. Our guide explains how credit risk is determined and what you can do to improve your overall credit health.
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How is credit risk determined?
Your credit history is the ultimate predictor of your credit risk. Lenders review your past financial actions in order to determine how likely you are to pay off your debt. The five Cs of credit are the key to getting funding from banks and other financial institutions.
It’s a system used by lenders to gauge an applicant’s creditworthiness and estimate the financial risk for the lender.
- Character: Your general trustworthiness and credibility are reflected by your credit history and work history.
- Capacity: Your ability to repay the loan, as assessed by your cash flows and debt-to-income ratio.
- Capital: The amount of money you’re able to invest. This typically applies to small business owners, who often use personal savings to start their business.
- Collateral: An asset you own that can serve as security for the loan, such as real estate.
- Conditions: The state of the economy, the purpose of the loan and the institution's ability to lend are all considered in lending decisions.
The five Cs of credit don’t always lend themselves easily to a numerical calculation, unlike a credit score. Each financial institution has its own method for analyzing a borrower's creditworthiness. Some institutions have dedicated departments just to evaluate risk and others use technology to speed up the process.
Regardless of their process, the five Cs of credit are a good starting point to follow when analyzing your own credit risk.
Your history gives lenders a better idea of what will happen if they give you a loan or extend you a line of credit. If you’re viewed as a high-risk candidate, you’ll either be denied for credit or wind up paying a higher interest rate.
How does credit risk affect you?
Your credit risk level affects things like interest rates and the types of loans and credit cards for which you may qualify. If lenders view you as a low credit risk, you’re more likely to receive larger loans, lower interest rates and more favorable repayment terms.
It’s possible to lower your credit risk by correcting any inaccurate or unfair negative items on your credit report, paying down credit card debt and making your payments on time.
What is credit risk management?
The goal of credit risk management is to lessen a bank’s risk of loss by assessing and managing the credit risk inherent in individual credit accounts. For most banks, loans are the largest and most obvious source of credit risk.
Banks and institutions typically use a comprehensive credit risk management solution to manage this. Here are a few things these solutions provide:
- Real-time scoring
- Credit limit monitoring
- Portfolio overviews
Sticking to the principles of the five Cs and having a general sense of their risk management process helps you understand how you are evaluated and how to keep your risk level low.
Are you a credit risk?
Unfortunately, many people are falsely identified as high credit risks because of inaccurate, unfair or unsubstantiated negative items in their credit reports. If you feel your FICO® Score is impacted by inaccurate items, consider challenging the questionable negative items impacting your score.
Lexington Law has helped hundreds of thousands of clients challenge these types of items for over a decade. You can call credit consultants at Lexington Law today to learn about our credit repair services to learn how we can help you ensure your information is fairly reported.