How is Credit Risk Mitigated

Credit risk is assumed by lenders when they loan money to people. It is the risk that the lenders run that the borrower will default on the loan; it includes the possibility of non-payment of the original principle amount or the interest owed on the loan. It can also mean there is non-payment on both the principle and the interest.

Default in this instance means that the payments owed on the loan have been late. In this case, the borrower and the lender can re-negotiate the terms of the loan. This can mean that the borrower is allowed to make lower monthly payments, but this is still considered to be a loan in default. A borrower can also file for bankruptcy in the event that an agreement could not be reached to lower the monthly payments. A borrower who files for bankruptcy may possibly lose the obligation to repay the loan.

Credit risk also refers to the bond market. The credit rating of the company that issues bonds informs investors of how high the probability is that the company will not make its interest payments. If a company has a high credit rating, the investor has less of a chance of earning a high return in interest, because the company is highly likely to make their interest payments. A low credit rating raises the credit risk, but the investors have the opportunity to make a lot more money from these companies provided that the companies make their interest payments.

In order to mitigate the credit risk that investors would have to tolerate in the bond market is a matter of knowing the company's credit rating. As explained above, a high credit rating brings in a lower rate of return on investment, but if it is more important to lessen the risk of default than it is to earn the most money on the investment, then the investor will choose to only purchase bonds from companies with high credit ratings at a lower interest rate.

Lenders also have a way of diminishing the credit risk they are subject to when they loan money. Lenders may loan money to businesses, but they also may loan money to individuals. Each individual person has a credit history and investors are advised to run a credit check on the people who are in search of a loan. Just like with the companies, those who have high credit scores are considered to present a low credit risk, while those who have low credit scores create a bigger risk. Lenders generally lower this risk by charging people with low credit scores much more interest than they do those with high scores. In this way it is opposite from the bond market with lenders making the most money from people with lower credit ratings.

The other thing lenders can do to lower their credit risk is to set a limit under which credit scores cannot fall before they will lend money. Poor credit scores are considered to be between 340 and 619. These credit scores reflect the scorers' history of non-payment of bills. They also may have a bankruptcy or repossessions on their records. They may have had a foreclosure and regularly late payments on their utilities. As lenders may believe that this type of history may continue into the future, they will be wary of lending money to them. Therefore, lenders who refuse to extend loans to people who fall into the poor range lessen their credit risk.