The risk of loss resulting from a borrowers inability to repay its loan obligations. When a borrower is given funds from a lender, there is always risk that the borrower may not be able to meet its obligatory principal and interest payments. Although impossible to quantify, managing credit risk may reduce risk of loss. Common methods of managing credit risk on loans include assessing a consumer’s credit history, ability to repay, and access to capital. A lender may also look at loan conditions and the collateral securing the loan, to ensure that the risk of loss is compensated for.
Interest payments serve as reward to the lender for taking on credit risk. Typically in cases where a borrower has a high chance of default, interest rates will be higher. For example, an investor will earn a higher yield on junk bonds compared to investment-grade bonds due to the increased risk of the issuer defaulting.