Credit Risk: Definition, Role of Ratings, and Examples

Investopedia contributors come from a range of backgrounds, and over 24 years there have been thousands of expert writers and editors who have contributed.

Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

What Is Credit Risk?

Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a loan. Essentially, credit risk 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. Lenders can mitigate credit risk by analyzing factors about a borrower's creditworthiness, such as their current debt load and income.

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.

Key Takeaways

• Credit risk is the potential for a lender to lose money when they provide funds to a borrower.
• Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
• Consumers who are higher credit risks are charged higher interest rates on loans.
• Your credit score is one indicator that lenders use to assess how likely you are to default.

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 can describe the chance 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 often look at the five Cs of credit: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.

Some companies have established departments responsible for assessing the credit risks of their current and potential customers. Technology has allowed businesses to quickly analyze data used to determine a customer's risk profile.

Bond credit-rating agencies, such as Moody's Investors Services and Fitch Ratings, evaluate the credit risks of corporate bond issuers and municipalities and then rate them. If an investor considers buying a bond, they will often review the credit rating of the bond. If a bond 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 lower.

Credit Risk vs. Interest Rates

If there is a higher level of perceived credit risk, investors and lenders usually charge a higher interest rate.

Creditors may decline a loan to a borrower they perceive as too risky.

For example, a mortgage applicant with a superior credit rating and steady income is likely to be perceived as a low credit risk, so they will likely receive a low-interest rate on their mortgage. In contrast, an applicant with a poor credit history may have to work with a subprime lender to get financing.

The best way for a high-risk borrower to get lower interest rates is to improve their credit score. If you have poor credit, consider working with a credit repair company.

Similarly, bond issuers with less-than-perfect ratings offer higher interest rates than those with perfect credit ratings. The issuers with lower credit ratings use high returns to entice investors to assume the risk associated with their offerings.

How Do Banks Manage Credit Risk?

Banks can manage credit risk with several strategies. They can set specific standards for lending, including requiring a certain credit score from borrowers. Then, they can regularly monitor their loan portfolios, assess any changes in borrowers' creditworthiness, and make any adjustments.

What Are the Five Cs of Credit?

The five Cs of credit include capacity, capital, conditions, character, and collateral. These are the factors that lenders can analyze about a borrower to help reduce credit risk. Performing an analysis based on these factors can help a lender predict the likelihood that a borrower will default on a loan.

How Do Lenders Measure the Five Cs of Credit?

Each lender will measure the five Cs of credit (capacity, capital, conditions, character, and collateral) differently. Generally, lenders emphasize a potential creditor's capacity, or the amount of income they have relative to the debt they are carrying.

The Bottom Line

Credit risk is a lender's potential for financial loss to a creditor, or the risk that the creditor will default on a loan. Lenders consider several factors when assessing a borrower's risk, including their income, debt, and repayment history. When a lender sees you as a greater credit risk, they are less likely to approve you for a loan and more likely to charge you higher interest rates if you do get approved.

1. Board of Governors of the Federal Reserve System. "Credit Risk Management."
2. Capital One. "What Are the 5 C’s of Credit?"
3. Accounting Tools. "Credit Risk Definition."
4. Consumer Financial Protection Bureau. "What is a Credit Score?"
5. Fitch Solutions. "Fitch Credit Ratings Data."
6. Moody's Analytics. "Credit Risk Solutions."
7. Experian. "How to Improve Your Credit Score."
8. Fidelity. "Bond & CD Price, Rates, and Yields."
9. Bank for International Settlements.org. "Principles for the Management of Credit Risk," Pages 1–2.
10. Wells Fargo. "Five Cs of Credit."

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

Credit is a contractual agreement in which a borrower receives something of value immediately and agrees to pay for it later, usually with interest.

Chapter 11 is a type of bankruptcy generally filed by businesses and involves a reorganization of their assets and debts under court supervision.

A quick-rinse bankruptcy is a bankruptcy proceeding that is structured to move through legal proceedings faster than the average bankruptcy.

A debt avalanche is an accelerated system of paying down debt that is based on paying the loan with the highest interest rate first. Learn how to use the debt avalanche.

A credit rating is an assessment of the creditworthiness of a company or government—in general terms or with respect to a particular debt or financial obligation.

• About Us
• Terms of Service
• Dictionary
• Editorial Policy
• Advertise
• News
• Privacy Policy
• Contact Us
• Careers
• EU Privacy

We Care About Your Privacy

We and our 100 partners store and/or access information on a device, such as unique IDs in cookies to process personal data. You may accept or manage your choices by clicking below, including your right to object where legitimate interest is used, or at any time in the privacy policy page. These choices will be signaled to our partners and will not affect browsing data.

We and our partners process data to provide:

Store and/or access information on a device. Use limited data to select advertising. Create profiles for personalised advertising. Use profiles to select personalised advertising. Create profiles to personalise content. Use profiles to select personalised content. Measure advertising performance. Measure content performance. Understand audiences through statistics or combinations of data from different sources. Develop and improve services. Use limited data to select content. List of Partners (vendors)