What is credit risk?
Remember your friend who “forgot” to pay you back… two years ago?
People and companies who fail to pay back their debts pose the largest risk to banks. When lending money to someone, there’s always a chance they won’t pay you back. This is credit risk.
Banks have ways of reducing this risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.
- Credit history, also known as character, is basically your track record for repaying debts.
- Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.
- If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.
- Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.
- Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.
The bank’s assessment determines how much interest they’ll charge you. If you are seen as a risky customer, for example by having a bad credit history, your loan will be more expensive.