Credit risk refers to the likelihood that a borrower will default on their debt obligations. When an entity has a high credit risk, it means that there is a greater probability that they will be unable or unwilling to pay back their debts. This can result in delayed payments, loss of investment principal, and the need for legal action to recover losses. Higher credit risk is often accompanied by higher interest rates on loans or investments, as lenders or investors seek to compensate for the increased risk. Credit risk can vary over time depending on the financial condition of the borrower.
Here are some examples of credit risk:
- A small business owner takes out a loan to expand their business, but their sales do not increase as expected and they are unable to make the loan payments. This is an example of credit risk for the lender.
- An individual takes out a mortgage to buy a house, but then loses their job and is unable to make the monthly mortgage payments. This is an example of credit risk for the mortgage lender.
- A company issues bonds to raise capital, but then experiences financial difficulties and is unable to make the required bond payments. This is an example of credit risk for the bondholders.
- A bank makes a loan to a customer with a poor credit history, and the customer defaults on the loan. This is an example of credit risk for the bank.
- An investor buys shares of stock in a company, but the company’s financial performance deteriorates and the stock value declines. This is an example of credit risk for the investor.