Mitigating Credit Risk: Essential Strategies for Borrowers and Lenders

Credit risk is the type of risk that creditors take on when they loan money to individuals or businesses. This risk is associated with the chance that a borrower will not be able to repay the debt. Every creditor has to deal with this risk in some way every time it makes a loan. Here are a few tips to remember when trying to avoid credit risk.

1. Debt-to-Income Ratio

When you are evaluating an individual or a business for credit, you need to look at his or its debt-to-income ratio. The debt-to-income ratio can tell you a lot about the potential borrower's financial situation. In order to calculate this, you need to calculate the loan applicant's total monthly debt payments and divide that by the applicant's total monthly income. The higher the ratio is, the higher the chance is that the individual or business will default on the debt. An individual or a business that has a large amount of debt already may not be able to handle the payments that will be required to repay the loan. Because of this, you should avoid borrowers that have high debt-to-income ratios.

2. Credit Score

You should also be sure to get a copy of an individual's credit report and look at his credit score. If you are lending money to a business, you can also get a copy of the business's credit report and score. A credit score is a number derived from a complicated formula that looks at a borrower's credit history. It is based on factors like payment history, total debt and the number of accounts that the borrower has. If the borrower has a high credit score, this means that he or it is considered to be a good credit risk. When you are lending money, you should work only with borrowers that have high credit scores. Otherwise, you are taking on an unnecessary risk.

3. Income

In order to repay the debt, the borrower will have to have a certain amount of income. You need to decide how much income an individual or business should have based on how much money he or it is trying to borrow. If you do not think that the loan applicant will have enough money to repay the debt in the future, then you should avoid lending the money. Every lender uses a specific ratio based on how much disposable income a borrower has to have before taking on additional debt. Determine what your minimum ratio must be and stick to it when lending money.

4. Collateral

Another way to avoid credit risk is to require the borrower to put up some type of collateral. Collateral will help you recoup the money that you have lent if the loan goes into default. For example, you could make a borrower give you his car if he is unable to repay the money that he has borrowed.