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What is Bankruptcy Risk?

Article Details
  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 08 August 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Also known as default risk or insolvency risk, bankruptcy risk is the potential that an entity will be unable to honor its existing debt obligations. Both businesses and individuals are assessed for this type of risk when making application for any type of financial assistance, such as a loan, the extension of a line of credit, or a mortgage. The lender will look at all relevant factors and determine if the degree of bankruptcy risk is sufficiently low enough to warrant entering into a business relationship with the company or individual.

When attempting to evaluate the level of bankruptcy risk, most lenders will look closely at the credit score of the individual or business that is seeking to establish a working relationship. Ordering copies of the credit reports and going over them in detail will reveal important clues about how the entity has managed debts in the past, especially during periods when some type of issue affected the income level of the entity. An investigation of this type may prompt the lender to decide that the bankruptcy risk is too high, and turn down the application. At other times, the lender may see information that causes some concern, and choose to dialogue with the applicant in order to learn more about specific situations that took place in the past.

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In general, lenders prefer to do business with others who are highly likely to honor all the terms and conditions associated with the financial agreement. For this reason, many lenders develop an internal risk score approach that they use to decide if a particular applicant is eligible for a loan or a line of credit that carries a lower rate of interest. Depending on the results of that scoring activity, the applicant may still be eligible for financial assistance, but at a higher rate of interest. This is because the lender is assuming a larger degree of bankruptcy risk in order to approve the application.

Lowering bankruptcy risk is something that takes time. Applicants should take the time to obtain and check copies of all reports issued by the different credit reporting agencies. Efforts to correct mistakes and update any information that is no longer current should take place before applying for a loan or any type of credit. In situations where recent financial reversals have created negative items on the various credit reports, the applicant should take steps to resolve those issues as quickly as possible, and offset them with reports of payments on debt obligations made on time. While none of these strategies lead to an immediate reduction in bankruptcy risk, they will over time help the applicant to become eligible for more types of financial assistance, and make it easier to obtain a lower interest rate on various types of loans, credit cards, and mortgages.

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