Definition of 'Credit Risk'
There are a number of factors that can contribute to credit risk, including:
* The borrower's credit history: A borrower with a poor credit history is more likely to default on a loan.
* The borrower's financial situation: A borrower who is experiencing financial difficulties is more likely to default on a loan.
* The collateral for the loan: If the borrower defaults on a loan, the lender can sell the collateral to recover some of their losses. However, if the collateral is not worth enough to cover the full amount of the loan, the lender will still suffer a loss.
* The interest rate on the loan: A higher interest rate increases the cost of borrowing for the borrower, which can make it more likely that they will default on the loan.
Credit risk can be managed in a number of ways, including:
* Credit scoring: Lenders use credit scores to assess the creditworthiness of borrowers. A credit score is a number that reflects a borrower's credit history and financial situation. Lenders use credit scores to determine the interest rate and other terms of a loan.
* Loan underwriting: Loan underwriting is the process of evaluating a loan application to determine the borrower's creditworthiness and the risk of default. Loan underwriters will review the borrower's credit history, financial situation, and other factors to determine whether to approve the loan.
* Collateral: Lenders may require borrowers to provide collateral for a loan. If the borrower defaults on the loan, the lender can sell the collateral to recover some of their losses.
* Insurance: Lenders may purchase insurance to protect themselves against losses from credit risk. Credit insurance can cover the full amount of a loan or just a portion of the loan.
Credit risk is a complex and ever-changing concept. Lenders must be aware of the factors that can contribute to credit risk and the ways to manage it in order to protect themselves from losses.
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