What is the Potential Credit Risk of a Borrower?

For both lenders and borrowers, the worst-case outcome of any loan is a default due to a borrower’s inability to repay the loan.

This outcome damages both parties. For the borrower, the credit rating hit can be disastrous for future lending activity. The lender, meanwhile, loses both income and revenue and usually has to pay to cost to pass the debt on to a debt collection agency.

Given the potential impact, how is the potential credit risk of a borrower assessed? There are a number of simple factors involved, starting with the borrower’s credit history.

Some lenders have formed companies and departments to evaluate just this one factor. That’s how important it is, especially if significant risk factors are involved. These companies use sophisticated technology to make this evaluation, and the accuracy of the data they receive is constantly being fine-tuned.

Another important factor is the borrower’s ability to meet obligations, which is referred to as the capacity to repay. Having a high level of assets or savings can offset a dodgy credit history to some degree, especially if the credit history issues are fairly minor for the most part.

The conditions of the loan also play a role in the borrower’s credit risk as well. This often goes hand-in-hand with credit history. A borrower with a good history will get better terms that favor repayment, while a borrower with a bad history may be forced to pay a higher interest rate that increases the likelihood of non-payment and default.

Collateral is yet another element of the credit risk assessment. One of the best examples of this is a car loan—in this case, the car itself becomes a significant asset that can be repossessed fairly easily if non-payment occurs.

The final element of the equation is capital. Having significant financial resources will lower the credit risk of a given borrower, especially if those resources are liquid. Lenders tend to be far more forgiving in this situation, largely due to the fact that any serious level of capital decreases the credit risk considerably.