What Is Credit Default Risk?

Malcolm Tatum
Malcolm Tatum

Credit default risk is a term used to describe the degree of risk that a lender or creditor assumes when choosing to provide financing in some form to a debtor. The term may refer to the credit risk represented by an individual, a business entity, or even a country. In any form, the goal is to assess the level of risk that is involved in doing business with the client, and determine if that risk is considered acceptable in light of the potential benefits.

Evaluating an applicant's credit report is one way to determine credit default risk.
Evaluating an applicant's credit report is one way to determine credit default risk.

Assessing credit default risk is essential for financial institutions as well as other entities that choose to extend credit to customers. Banks, mortgage companies, and even debt consolidation lenders look closely at several different factors to determine how much of a chance exists that the debtor would default on the extension of credit. Doing so not only protects the interests of the lender, but also has the benefit of preventing the debtor from taking on more credit than he or she can reasonably manage.

When assessing credit default risk, lenders will typically begin by reviewing the current circumstances of the loan or credit applicant. This includes verification of a steady source of income, often focusing on wages or salaries earned from employment. From there, the standard and usual living expenses of the applicant are taken into consideration, including any current debt obligations. Along with evaluating this type of information, lenders will order and assess credit reports related to the applicant, paying close attention to not only the overall credit rating and score, but also any information submitted by former or current creditors that has to do with payment histories.

While any loan applicant is likely to represent some level of credit default risk, lenders typically utilize specific standards to determine if that risk is counterbalanced by the benefits derived from approving the loan or credit line. More conservative lenders will typically require a higher credit rating, extending more competitive interest rates to qualified candidates who represent lower credit default risk. There are also lenders who approve higher-risk loans or lines of credit, but do so with the provision for higher interest rates and possibly even annual fees. Those higher rates and fees help to offset some of the risk, making it possible for the lender to justify the extension of the credit. For a consumer who has experienced some damage to his or her credit rating in recent years, working with a high risk lender who has a reputation for reporting regularly to the credit bureaus can be a step toward improving credit ratings, and making it possible to secure better terms in the future.

Malcolm Tatum
Malcolm Tatum

After many years in the teleconferencing industry, Michael decided to embrace his passion for trivia, research, and writing by becoming a full-time freelance writer. Since then, he has contributed articles to a variety of print and online publications, including wiseGEEK, and his work has also appeared in poetry collections, devotional anthologies, and several newspapers. Malcolm’s other interests include collecting vinyl records, minor league baseball, and cycling.

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