Credit risk is hardly the first thing that comes to mind when you’re thinking about investing, but it should. It’s your money at stake. Even if there are no immediate implications of missing a payment, accepting too much debt can have more serious consequences down the line
The “what are the 5 factors that affect your credit score” is a blog post written by the team at Credit Karma. They explain why your credit risk should matter to you.
The probability of suffering a loss if one party to a financial transaction doesn’t fulfill their commitments is known as credit risk.
When discussing loans and the likelihood that a person or corporate organization will repay money they have borrowed, credit risk is often brought up. When issuing loans based on the borrower’s credit profile, banks and other lenders take on a certain degree of risk. Your credit risk was probably one of the considerations that affected the interest rate you paid if you’ve ever taken out a loan or a line of credit.
Investors should understand how to interpret this idea since it has an impact on returns for certain fixed-income assets. Here is a basic explanation of credit risk.
Related: What constitutes a poor credit rating?
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Recognizing Credit Risk
The context in which credit risk is being assessed will determine how you define it.
For instance, it is expected that debts made by banks or other lenders would be repaid. Credit risk takes into account the potential that the borrower won’t pay back what is due, causing the lender to experience disrupted cash flow, expenses to reclaim the money, and eventually a loss of money.
The same logic applies when a supplier offers a firm a line of credit. They are taking a chance that the company will pay them back promptly for the goods or services they have rendered.
Other forms of risk are connected to credit risk as well. Contrary risk, for instance, is the likelihood that one side in a credit, trade, or investment transaction won’t uphold their end of the contract. The likelihood that a party to a financial transaction will default or fail to make due payments on time is measured by this, which is also known as default risk.
When talking about bonds in the context of investment, another credit risk concept is relevant. A kind of debt is represented by a bond. An investor basically lends money to the bond issuer when they buy a bond for a certain amount of time. The bond issuer pays interest to the investor during this term. The bond’s issuer returns the investor’s initial investment when the bond matures.
Assuming the bond issuer will pay interest and repay the investor’s capital, the investment is done in good faith. Credit risk is the possibility that the bond issuer may break their half of the bargain. Investors may evaluate if a bond investment has a greater or lower degree of credit risk using credit ratings.
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The Credit Five C’s
When measuring credit risk, it’s common to turn to The Credit Five C’s. These are five factors used to evaluate how likely an individual or business is to follow through on their end of a financial contract.
The Credit Five C’s are more often used in business lending than personal lending. If you’re getting a personal loan, line of credit or credit card, for example, lenders are more likely to consider your FICO credit scores. The FICO credit score range runs from 300 to 850, with 850 being the highest score you can achieve.
Here is a breakdown of the five C’s keeping that in mind.
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1. Personality
Character evaluations consider a borrower’s past. This might include things like their degree of schooling, work history, and general reputation. When awarding company loans, lenders may additionally use a borrower’s personal credit history to assess their character and credit risk.
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Cash Flow 2.
The movement of money into and out of a firm is known as cash flow. Cash flow and the capacity to repay debt are often used interchangeably in lending contexts. Revenues, costs, and cash flow from the firm may all be used by lenders to assess credit risk.
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Capital 3.
The amount of money you’ve personally put in your company, or “skin in the game,” is what is referred to as capital. The likelihood that you will default on a loan and put the firm at risk decreases the more money you have invested in the enterprise. In terms of determining credit risk, that’s advantageous.
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4. Situations
Conditions is the general market for the company. Lenders, for instance, will consider the level of demand for the goods and services your company provides as well as that of your rivals. Your prior experience running a company of this kind may also be relevant.
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5. Supporting
By forcing you to provide some kind of security against a loan, collateral is utilized to reduce credit risk. For instance, if you need a loan to acquire equipment, the actual piece of equipment itself may be used as collateral. In the event of a failure on the loan, the lender has the right to seize and sell the equipment in an effort to recuperate some of its losses.
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Interest Rates and Credit Risk
Interest rates and credit risk are related, both in terms of potential borrowing costs and potential investment returns. Both sides of the connection are inverted.
For instance, a better credit score might result in lesser credit risk and, as a result, cheaper interest rates when lending money. A lower credit score may increase the credit risk and interest rates associated with investing.
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Why Borrowers Should Care
Because it may directly impact the cost of borrowing, credit risk is important to borrowers. The riskier you can seem to lenders, the worse your credit score is. The lender could impose a higher interest rate to counteract this risk.
You usually wind up paying more toward the interest than the principle early on in the loan’s term when that interest is amortized. In order to offset the possibility that you would eventually fail, this enables the lender to receive the majority of the interest up front.
Therefore, when the perceived credit risk is larger, higher interest rates act as a form of insurance policy for the lender. However, it eventually implies that borrowing money costs more for you.
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Why Investors Should Care
Interest Rates and Credit Risk also matter to investors when trading bonds. Bonds with better credit ratings are likely to have less credit risk, as there’s less potential for the bond issuer to default. But they may carry lower interest rates as a result. On the other hand, bond issuers with lower credit ratings may offer higher interest rates to incentivize investors to purchase them.
If you’re trading on margin, you might potentially expose yourself to credit risk. Margin trading is taking out a loan from a brokerage to make investments. This is how margin accounts operate:
- You make a minimum margin deposit of $2,000 in accordance with FINRA regulations, but certain brokerages may demand more.
- You are permitted by your brokerage to borrow up to 50% of the cost of margin securities (this is known as initial margin)
- Going ahead, your brokerage expects you to adhere to a maintenance margin level.
Due to your usage of borrowed funds for investments, there is a credit risk. You run the risk of losing money if your investments don’t perform as predicted, but you’d still have to pay the brokerage. This may occur if you get a margin call and your account balance falls below the maintenance margin threshold. In most cases, you won’t be able to make new investments if you’re the target of a margin call unless you contribute more money to your account.
What you should understand about margin balance
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Assessing Credit Risk: A Guide
The method for assessing credit risk depends on the situation in which it’s being measured. As already mentioned with business lending, lenders rely on The Credit Five C’s to gauge a borrower’s credit risk. These five factors, along with personal and business credit score and their overall financial position can help determine how likely a borrower is to keep up with their debt obligations.
Investors may utilize government credit ratings as a guidance when making investments, especially with bonds. One of the most well-known companies that publishes bond credit ratings is Moody’s. The Securities and Exchange Commission (SEC) has nine credit rating agencies registered as NRSROs, or nationally recognized statistical rating organizations (SEC).
However, it’s crucial to keep in mind that credit scores by themselves may not always serve as a reliable predictor of risk. To determine if a certain bond is a wise investment, you must also consider your own personal risk tolerance and the characteristics of the investment. All of this is a component of doing due diligence, which is crucial for risk management, particularly the management of credit risk.
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What Credit Risk Means for You
What Credit Risk Means for You depends on how you invest or borrow money. If you own bonds, for example, you’re assuming a certain amount of credit risk based on the quality of the bonds in your portfolio. A bond with a AAA credit rating, for example, is less of a credit risk compared to a bond with C rating.
If the bond issuers honor their commitment to pay interest, choosing to invest in trash bonds, which involve a greater level of credit risk, can turn out to be advantageous. However, since the bond has a weaker credit rating, you are taking on more risk in exchange. Therefore, it’s important to know your own risk tolerance while selecting assets.
Decisions about borrowing are also influenced by credit risk. Obtaining a loan or line of credit with a cheaper interest rate may be simple if you have a high credit score. On the other side, having fair or poor credit may result in you having to pay higher interest rates. You may be able to get better interest rates if you take actions to raise your credit score.
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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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