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What is Credit Risk?
John Spacey, August 19, 2015 updated on March 21, 2021
Credit risk is a potential that an organization, business or person is unable or unwilling to pay a debt. Typically, investments with a higher credit risk pay a higher rate of interest. Credit risk fluctuates with time as the financial condition of a debtor changes. Credit risk can result in a delayed flow of payments, loss of principle and in many cases results in legal costs as creditors may need to launch legal action in an attempt to recoup losses. The following are a few examples of credit risk.
1. BondsBonds issued by governments, organizations and businesses are typically rated for their credit risk by organizations known as Bond Rating Agencies. The interest paid on a bond depends upon these ratings and the appetite for credit risk in financial markets.
2. LoansLoans to organizations, businesses and individuals include a wide variety of financial products such as mortgages, lines of credit and credit cards. Loans may be secured or unsecured with a secured loan being based on the value of an asset that will be sold to pay the debt under certain conditions. Financial institutions that make loans may use a variety of credit rating agencies to calculate credit risk. Interest rates are usually based on such risks. For example, unsecured loans often have a higher interest rate than secured loans.
3. Accounts ReceivableCompanies that sell things typically have customers that owe them money. These debts are known as accounts receivables. Customers have incentive to keep their money as long as possible and often try to delay payments. Customers who are in poor financial condition may delay payments for long periods of time even when legal actions are taken to recover funds. In some cases, customers will ultimately fail to pay due to bankruptcy or as the result of some dispute. According to accounting rules, companies must regularly judge the credit risk associated with their accounts receivable and recognize losses for doubtful accounts.
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