What Is Credit Risk? It’s the Ability to Repay a Loan
Credit risk is a measure of a borrower’s ability to repay a loan and the interest charged on that loan. The borrower can be a person or business. By assessing credit risk, banks can maximize their profits by extending credit to only those borrowers most likely to pay them back, and reduce their losses by not extending credit to those who may default on their loans.
Often, borrowers who are considered to be a low credit risk are offered better rates of interest.
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What Is Credit Risk Analysis?
Credit risk analysis is the procedures by which a lender organization will determine a potential borrower’s credit risk. This is a multi-step process. Typically, when considering a request for a loan, the bank or lender will:
Run a Credit Check on the Borrower
A credit check is a report that shows the borrower’s credit and payment history, and if the borrower has any other loans that are in arrears. It will also show how much credit the borrower has elsewhere.
This report will give the lender a good idea on whether the borrower meets his financial obligations, and if they are met on time.
In the United States, there are three major credit bureaus:
Credit bureaus do not decide whether an individual or business should get a loan, they just provide information so a bank or lender can make an informed decision. Credit agencies are not government run, they charge for their reports, but the government does mandate how they operate.
When a bank or lender looks at a credit report, they will see that the agency has assigned a three-digit number to the borrower. This number ranges from 300 to 850.
Let’s use an example of how a credit report can help a bank decide whether to give a loan or not.
Andrew Johnson lives in San Diego, California. He goes to a local bank in the hopes of getting a loan to get his small business off the ground. He already has an account at the bank but no credit cards. As part of the bank’s loan procedures, the bank representative will do a credit check on Andrew.
The banking representative goes online to access Andrew’s credit report, which he can do quickly on his computer. The credit report shows that Andrew typically pays his credit cards and other bills when they are due. In other words, he has managed his credit well. In fact, his credit score is 720. There will be other considerations for the bank, but as a starting point, this solid credit rating score puts Andrew in a good position to get the loan.
Ask for Employment letter
If it’s an individual asking for a loan, then the lender may ask for a letter of employment. This would be written by the HR department of the borrower’s company – outlining how long the individual has worked there, and the salary he makes.
We’ll use Andrew as an example again. Let’s say Andrew is not starting a new business but simply wants to get a new vehicle. He goes directly to the dealership. He does not need to go to the bank for the loan (unless he wants to) as most dealerships will deal with the bank for their customers.
However, the dealership doesn’t know Andrew, and as such they want to make sure he can make his monthly payments. So, the dealership representative asks for a letter of employment. In this case, the letter shows that Andrew has worked at his company for five years. The letter also shows his annual salary. This figure is a good indicator that the monthly payments on the car will not be a burden for Andrew. The dealership weighs this with the fact that Andrew is putting a deposit of $5,000 down on the vehicle. Ultimately, they decide to go ahead with the sale.
Ask for the Business Plan
What exactly is the company planning to do with the bank’s money? The bank will want to know. A business owner should be prepared with a business plan that shows how the money will be spent, what it expects to make in profit, and when.
Request the Company’s Financial Statements
When dealing with a business, the bank may want to see some of a company’s financial statements. For instance, they could ask for previous tax returns for the business, the income statement or the cash flow statement.
All of these statements will show the lender the business’s ability to make monthly payments.
Ask for a Credit Reference
In some cases, a bank may ask for references from a company the borrower does business with currently. These are businesses that have previously extended credit to the borrower, like a supplier. This will also show that the borrower meets his financial commitments.
Ask for Collateral
If the financial statements and credit history are good, but the loan is significant, the lending institution might ask for something as collateral. Collateral is something of value the borrower will give to the lender, if the loan is defaulted on. It is considered to be a form of security. Examples of collateral include cash, investments or a home. An expensive car could be considered collateral, but keep in mind it will depreciate quickly and the bank may not accept it.
Why Is Credit Risk Management Important?
Credit risk management is important to a bank or financial institution because it allows them to minimize their losses.
Every time a bank supplies credit, or gives a loan, it is putting itself at risk. The risk of not getting that money back. The bank must weigh the possibility of profits versus the risk of defaults. They do this by gathering as much information as possible about the borrower.
Risk management refers to more than just procedures for granting a loan. It also takes into account the bank’s big picture. Does a bank’s existing loan procedures leave enough in the bank’s reserves to cover any immediate losses?
The 2007 mortgage crisis was in part caused by too many homeowners with bad credit being granted mortgages. Leading up to that time, housing prices were high, but interest rates were low. Banks granted these mortgages even to people without proper documentation or good credit scores, just to get the business. Later, many people were granted second mortgages.
Shortly thereafter, home prices dropped dramatically and interest rates rose. Ultimately, many could not make their payments. The banks were on the hook for defaulted mortgages for homes they could not resell. As a result, many banks went out of business.
How Do I Establish Credit?
To establish credit, or to be seen as less of a credit risk, it takes time. You need to learn to:
Pay Your Bills
This does not refer to just your visa statement, but your mortgage payments, your hydro bill, your car lease. Anything you owe money on, must be paid when the money is due. This will help you to build a good credit score.
Pay Your Bills in Full
If you’re only making the minimum payment on a number of bills, then that is going to affect your credit score too.
Establish other credit
Sometimes not having enough credit can reflect on one’s credit history. If you only have one credit card, consider getting another. This is not a license to spend, you just want to show you can juggle multiple credit lines.
How long you’ve had a credit history is just as important as what’s in it. It takes time.
Build Business Relationships
If you’ve already got a business going, chances are other businesses are already providing you some credit simply by delivering a product and billing you for it later. Pay those bills in full when they are due. You never know, you may be able to use these business contacts as references later.
Save some money
You don’t want to go for a loan and have nothing in your account. Sock some money away first so that you have something to show when applying for credit or a loan.