What is Credit Risk? - Definition & Examples

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  • 0:04 What Is Credit Risk?
  • 1:37 Credit Risk Importance
  • 2:23 Credit Risk Assessment
  • 3:53 Credit Report
  • 4:34 Lesson Summary
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Lesson Transcript
Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

When you go and buy a car or a house, companies will assess your credit risk before allowing you to make such a big purchase. Learn why and how they do this in this lesson.

What Is Credit Risk?

Imagine yourself at the car dealer looking at the car you've always wanted. It's sitting right there in front of you. The sales person has just left to get the key so you can test drive it. Oh boy! You are so excited!

But hold your horses! After your test drive, you find out that before you can even begin the process of purchasing the car, the car company needs to look at your credit to see if you are even qualified to make such a purchase. What are they looking for? They're looking for your credit risk. Your credit risk is the possibility that you won't pay them the cost of the car in full. See, usually, when you make a big purchase such as a car, you'll get a loan. You'll pay the loan back in monthly installments for a number of years. Of course, you may plan on making these payments on time each month. But not everybody is like you. Some people aren't able to make these payments on time or even at all. For these people, the credit risk is high. And if the credit risk is too high, some companies won't do business with that person.

It's not just people that have credit risk. Investments such as bonds also have credit risk. This credit risk tells investors just how risky it is to get these bonds. The higher the risk, the higher the chances of losing money on the investment. The lower the risk, the lower the chances of losing money and the higher the chance of gaining money.

When you get a loan, your credit risk is calculated, but when you're thinking of investing, you calculate the credit risk of the investment.

Credit Risk Importance

Credit risk is important for both you and the company you are about to do business with. Having a low credit risk allows you to do business with so many more companies. This includes having access to credit cards. Having a high credit risk limits you to only the few companies that are willing to take a risk and do business with you.

Companies use assessment of credit risk to screen out the people that are least likely to pay them back. Most companies will run your credit check and if the credit risk is too high, then you'll be denied service. Some apartments do this too. If your credit isn't good enough, meaning your credit risk is too high, then you won't be able to get an apartment there. Alternately, some companies make you pay a higher interest rate if your credit risk is high.

Credit Risk Assessment

Different companies assess your credit risk differently. For smaller purchases such as cars, apartments, cell phone service, or utilities, the companies may look at just your credit score. A high or good credit score means you're good at paying back your debts. In these cases, a high credit score translates to a low credit risk.

So to allow you to purchase that favorite car of yours, all the company checks is your credit score. If it's high enough, then they'll let you buy the car. Fortunately for you, your credit score is high enough, which means the credit risk for the car company is low. And you're good to go. You drive off the lot with your brand new car!

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