Credit risk: What it is and how it works
July 27, 2023 5 min read
Credit is at the center of many major financial transactions, from securing a mortgage to financing a car or getting approved for a credit card. And from a lender’s point of view, whether to loan a person money or extend credit comes down to risk.
Learn more about how creditors use information like credit reports and credit scores to assess a borrower’s credit risk, make lending decisions and decide on loan terms.
- Credit risk assesses the likelihood that a borrower will pay back a loan.
- Credit risk is a factor in lending decisions.
- Credit risk is determined by various financial factors, including credit scores and debt-to-income (DTI) ratio.
- The lower risk a borrower is determined to be, the lower the interest rate and more favorable the terms they might be offered on a loan.
What is credit risk?
Credit risk measures how likely a borrower is to pay back a loan—whether it’s a mortgage, a personal loan or a credit card. Lenders consider a potential borrower’s credit risk to inform the decisions they make before extending them a line of credit. And in many cases, lenders use information like the applicant’s credit history and DTI ratio to assess credit risk.
Generally speaking, borrowers with higher credit scores are considered less risky to lenders. They may be viewed as more likely to pay back a loan on time and in full, so they are more likely to receive the loans they apply for. This is also why less-risky borrowers tend to receive better interest rates, oftentimes resulting in a lower overall payment on a debt.
Factors that impact a borrower’s credit risk level
Lenders might consider the 5 C’s of credit—character, capacity, capital, collateral and conditions—when assessing a potential borrower’s credit risk. Here are a few other key factors that lenders might look at before backing a loan:
Credit scores and credit history
A credit score is a numerical rank—typically from 300 to 850—that reflects how likely a borrower is to pay back a debt.
There can be a lot to it, but credit bureaus—like Experian®, TransUnion® and Equifax®—compile credit reports. And the information in those reports is used by credit-scoring companies—like FICO® and VantageScore®—to calculate credit scores. Because there are various credit reports and scoring models, borrowers have more than one score that lenders might use.
According to the Consumer Financial Protection Bureau (CFPB), credit scores take into consideration a few of the following factors:
Creditors may also evaluate a borrower’s DTI ratio to determine their overall credit risk. The DTI ratio refers to the amount of a borrower’s income that goes toward paying debt. Lenders will look at a borrower’s front- and back-end DTI ratios when assessing credit risk.
The front-end DTI ratio is the calculation of the borrower’s housing expenditures, like mortgage payments, monthly rent or homeowners or renters insurance premiums. The back-end DTI ratio includes the borrower’s housing expenditures plus any other monthly debts.
Lenders typically recommend maintaining a front-end DTI ratio that’s less than 28% and a back-end DTI ratio that’s less than 36%. A lower DTI ratio can show creditors that a borrower can take on additional monthly payments. You can calculate your personal DTI ratio by dividing all your monthly obligations by your total gross salary.
Collateral refers to assets—like real estate or a car—that can be used to back a loan.
When it comes to secured loans, collateral might be part of a loan agreement. One example is a house as part of a mortgage. Unsecured debt—like credit cards or student loans—isn’t backed by collateral.
When it comes to credit risk, collateral might be a factor in assessing risk. That’s why when comparing secured debt versus unsecured debt you may find that secured loans tend to have lower interest rates than unsecured loans.
Benefits of having a low credit risk
Having a lower credit risk can help a borrower get approved for a loan more easily. Borrowers with a higher credit risk may have a longer approval process before a determination can be made.
Being a low-risk borrower also means interest rates may be lower on certain loans, like a low fixed-rate mortgage. This can keep more money in a borrower’s pocket over time, which is just one of the many benefits of having high credit scores and a lower credit risk.
Credit risk can also influence things like credit limits, or the total amount of available credit extended to a borrower by a lender.
Ways to improve your credit risk
Credit scores are one indication of credit risk, so making an effort to improve your credit scores can help. Here are some ways you might be able to boost your scores and lower your credit risk:
- Pay your bills on time, every time. Credit-scoring models typically take into account the timeliness of monthly payments when calculating a score. Paying bills on time every month can help you avoid a late fee and improve your score.
- Monitor credit scores. Monitoring your credit scores can help you better understand where you stand and stay up to date on any changes made to your report. You could use a free tool like CreditWise from Capital One to monitor your credit.
- Start building credit early. A long credit history proves your trustworthiness as a borrower. Those looking for a card with easier approval odds can consider opening a secured credit card. Making on-time payments each month can help you avoid accruing interest while keeping a low credit utilization ratio.
- Maintain a low utilization ratio. Lenders also evaluate the amount of available credit you have when assessing your risk. According to the CFPB, keeping your credit use below 30% shows potential lenders you’re managing your balances responsibly.
Credit risk in a nutshell
Before securing any type of loan, creditors will evaluate credit risk to determine eligibility and loan terms. To assess this risk, most lenders take into consideration things like a borrower’s credit scores, DTI ratio and total debt.
CreditWise can help. It provides your VantageScore 3.0 credit score and monitors credit reports from TransUnion and Experian, two of the three major credit bureaus. CreditWise is free for everyone—whether or not you have a Capital One card—and using it won’t hurt your credit scores.
And you can get a free copy of your credit reports from each of the three major credit bureaus by visiting AnnualCreditReport.com.