What is credit risk? Definition, types and how it's measured

If you wondered why a lender asked so many questions when you applied for a loan, it’s very likely it was due to credit risk. By understanding credit risk, and how lenders evaluate it, you may be able to help position your business to get approved for the financing your business needs.

At a minimum, it can help you avoid common pitfalls that may flag your business as high risk.

What is credit risk? 

Credit risk is the risk that borrowed money won’t be paid back. It is the possibility that a borrower — or counterparty — will fail to repay a debt obligation.

When a lender reviews your application for credit, or reviews your loan periodically, they are asking themselves, “How likely is it that this borrower won’t pay back the loan as agreed”?

Credit risk affects both lenders and borrowers. 

• For borrowers: being seen as a higher credit risk can mean paying a higher interest rate, getting approved for less money than you asked for, or being denied credit altogether.
• For lenders: a borrower who defaults means the lender could lose the principal they lent out, plus any interest they expected to earn.

Why is credit risk important?

Credit risk is core to small business lending and financing. Every credit decision involves some evaluation of credit risk. 

For lenders: Banks, financial institutions and companies that offer financing use credit risk to decide who to lend to, how much to lend, and what to charge. A lender that takes too little risk may not get enough customers to sustain its business, but a lender that takes too much risk may go out of business. 

For borrowers, understanding credit risk gives you power. When you know what lenders are looking for, you can take steps to position your business as less risky — which can mean better loan terms, lower interest rates, and more access to capital.

In the Federal Reserve’s Small Business Credit Survey (fielded in 2023), low-credit-risk applicants were much more likely to be approved — e.g., 83% at small banks and 76% at large banks compared to roughly 50% for medium- or high-risk firms.

Credit risk also affects the health of the overall economy. Think back to the credit crisis of 2008. When large numbers of borrowers default at the same time, it can send ripple effects through financial markets and communities, and even lower-risk borrowers can see their credit limits cut or their lines of credit closed. 

What are the main types of credit risk?

Credit risk comes in different forms, and lenders may look at credit risk in various ways. 

Default risk

Default risk is the risk that a borrower won’t make their scheduled payments. A borrower defaults when they don’t meet their debt obligations. This is the outcome lenders work hardest to predict before approving any loan.

It is the most common type of risk business owners are familiar with, and it’s a risk that many credit scores are designed to measure. 

Default can mean missing a loan payment, failing to repay a loan or line of credit, or going out of business and leaving debts unpaid. For small business owners, default risk is what most lenders are trying to evaluate when they review your credit scores and credit reports.

Concentration risk

Concentration risk is when a lender has too much of its lending tied to a single borrower, industry, or geographic region.

If a lender makes too many loans within a specific industry and that industry takes a sudden downturn, the lender may not be able to manage all those losses. 

That means that if your loan is rejected, sometimes it’s not you, it’s the lender.

Counterparty risk

Counterparty credit risk is the risk that the other party in a financial transaction won’t fulfill their side of the transaction. 

This type of risk can be very complex, and in the banking industry, often takes into account currency trading and derivatives risk. 

For a small business, one way lenders may evaluate counterparty risk is by requiring copies of contracts with key customers. They know if you don’t get paid, you probably won’t be able to pay your loans.

Sovereign risk (country risk)

Sovereign risk — also called country risk — is the risk associated with lending to or doing business with entities in a foreign country. This includes the possibility that a foreign government might default on its debts, or that political instability, currency fluctuations, or policy changes could disrupt repayment.

While this may seem like a distant concern to some small businesses, recent tariffs have magnified country risk. Many U.S. businesses have learned the hard way that they are dependent on foreign businesses., either directly or indirectly. 

Settlement risk

Settlement risk is the risk that one party in a transaction delivers their side of the deal — money or assets — but the other party fails to deliver in return.

I experienced this firsthand in my consulting business when a company I partnered with failed to pay me as agreed for the product I created for them to sell. I kept up my end of the deal, but they didn’t keep up their end, and pocketed several tens of thousands of dollars they owed me.

I didn’t lend money, but I invested my time and expertise, and was not paid. 

How credit risk is assessed and measured

Lenders can use a combination of quantitative (numbers-based) and qualitative (judgment-based) tools to assess how likely a borrower is to repay.

Credit scores and ratings

When we think of credit risk, most of us think of credit scores. In consumer lending, FICO^® and VantageScore^® credit scores are often used to help evaluate the risk of extending credit, including mortgages, credit cards, and auto loans. 

Experian, Equifax, and Dun & Bradstreet create a variety of business credit scores that are used for business credit card decisions. 

Institutional credit ratings

For larger businesses, organizations, and governments, rating agencies like Moody’s, S&P, and Fitch evaluate creditworthiness on a letter-based scale. At the top end, AAA signals the lowest credit risk and highest ability to repay. Ratings move down through AA, A, and BBB — the lowest “investment grade” tier. Below that is below-investment-grade territory (sometimes called “junk”), running through BB, B, CCC, and ultimately D for default

Key credit risk metrics

Probability of default (PD): This measures the likelihood that a borrower will fail to meet their debt obligations within a specific time frame, usually one year. In simple terms: what are the odds this borrower doesn’t pay?

Loss given default (LGD): If a borrower defaults, how much of the outstanding loan will the lender actually lose? This accounts for the fact that lenders can sometimes recover a portion of what they’re owed through collateral or collections.

Exposure at default (EAD): This is the total amount a lender has at risk at the moment a borrower defaults — the full outstanding balance owed at that point in time.

The 5 Cs of credit: framework for credit risk analysis

Before modern credit scoring models existed, lenders relied on their best judgement to evaluate loan applications. The popular framework they created — often called the 5 Cs of credit — is still widely used today, including for small business loans.

Character

Character is a lender’s assessment of your trustworthiness and your track record of meeting financial obligations.

Capacity

Capacity measures your business’s ability to repay the loan. 

Capital

Capital refers to the money you — the business owner — have personally invested in your business.

Collateral

Collateral is an asset you pledge as security for the loan. If you’re unable to repay, the lender has the right to seize and sell that asset to recover what they’re owed.

Conditions

Conditions refers to the broader environment surrounding the loan — both what the loan is for and the economic climate at the time.

What goes into a FICO® score: the big 5 factors

FICO^® scores are the most commonly used consumer credit scores, and VantageScore^® is their primary competitor. Understanding the main FICO score factors can help you understand the steps you may be able to take to build your credit. 

All of these factors are trying to help assess risk, and some factors are heavily associated with more (or less) risk: 

Payment history — 35%

This is the single most important factor in your FICO score. Late payments, bankruptcies, and collections can significantly hurt your scores. Recent negative items are especially risky.

Paying on time over time can help build strong credit scores. 

Amounts owed (credit utilization) — 30%

This factor looks at how much of available credit you’re currently using. It compares the reported balance to your credit limits on your credit cards and any other revolving accounts. There’s no specific percentage you must stay below to have good credit scores, but FICO says that consumers with the highest scores tend to use less than 10% of their available credit. 

Length of credit history (credit age) — 15%

This factor looks at the oldest account, youngest account, and average age of accounts. A longer or older credit history is considered less risky. 

New credit (inquiries) — 10%

New accounts and multiple inquiries are associated with higher credit risk. Not all inquiries affect your credit scores. (Soft inquiries don’t affect credit scores, while hard inquiries do.) 

Credit mix — 10%

A mix of different types of accounts — revolving accounts like credit cards and installment accounts like auto loans or mortgages — may help you build stronger credit scores.

For a deeper dive at each of these factors and how to approach them, check out Nav’s full guide: 5 main credit scoring factors.

How does credit risk influence interest rates?

Credit risk can directly impact the rates and fees you may be charged when you borrow. Risk-based pricing is common with credit cards and other types of financing. 

When a lender reviews your credit reports, credit scores, and application, they will often take into account the level of risk when deciding what to charge. This isn’t always the case: suppliers who offer net-30 terms don’t usually charge interest and risk is only considered to approve or decline your application. 

Research from the Federal Reserve confirms that loan characteristics — including credit scores — are key pricing factors for loans such as credit cards and mortgages. 

Risk-based pricing applies across all major loan types:

Mortgages: A borrower with a strong credit score and/or low loan-to-value ratio (LTV) will typically be offered a lower mortgage rate.

Auto loans: Higher-risk borrowers often pay more to finance a vehicle. 

Credit cards: Interest rates on credit cards vary widely based on the applicant’s credit risk profile.

Business loans: For small business owners, credit risk may directly affect both the rate and the terms of a loan. The SBA notes that lenders use credit scores to determine credit risk and set interest rates on business loans. If you’re seen as a high-risk borrower, you may also be offered a smaller loan amount or shorter repayment terms.

If your personal credit report or consumer credit score was used to offer you less favorable terms for a consumer-purpose loan, you must be provided with a risk-based pricing notice that tells you which credit bureau they used to get your report, how you can get a free copy of your credit report, and your credit score (if used). 

Learn more about what lenders must tell you when you are turned down for a small business loan. 

Credit risk management strategies

Learning how to manage credit risk can benefit you both as a borrower and lender. 

And just because you run a business, not a bank, doesn’t mean you shouldn’t care about credit risk like a lender. If you provide anything of value before you are paid for it, you want to make sure you’re taking risk into account.

For lenders

Diversification: Lenders spread their credit exposure across different borrowers, industries, and regions to reduce concentration risk. No single borrower or sector failure should be able to destabilize an entire portfolio. 

Similarly, as a business owner, try not to rely too heavily on one client or even one supplier. 

Regular portfolio monitoring and stress testing: Lenders continuously review the health of their loan portfolios and run scenarios to test how those portfolios would hold up under different economic conditions.

As a business owner, you can review business credit on your key clients or suppliers. 

Use of credit derivatives and insurance: Larger institutions can use financial instruments to transfer portions of their credit risk to other parties, reducing their own direct exposure.

As a business owner, you might consider invoice factoring as one way to reduce risk. 

Setting appropriate credit limits and covenants: Lenders manage risk by setting borrowing limits and attaching conditions (covenants) to loans that require borrowers to maintain certain financial standards throughout the life of the loan.

As a business owner, you may want to ask for deposits, or set up payment schedules with incentives for early payments, or penalties for late payments. 

For borrowers

As a business owner, managing your credit risk profile — with both personal credit and business credit — can be one of the most impactful things you can do to improve access to financing and to lower your cost of borrowing.

Maintaining strong payment history: Since payment history is the most important factor in virtually every credit scoring model, paying your accounts on time — both business and personal — can be a high-impact habit.

Keeping credit utilization low: Try to pay off credit card balances quickly whenever possible. Avoid using personal credit cards for business debt, as credit utilization can be a significant factor in consumer credit scores. 

Build emergency reserves: Cash reserves give you a safety net when cash flow is tight, and lenders often look at your cash flow when evaluating loan applications.

Monitor your credit reports regularly: Check your credit reports and credit scores for mistakes or sudden changes that could indicate fraud or id theft. 

Understanding loan terms and covenants: A loan agreement is a contract, and before you sign it, read it. Understand what you’re agreeing to, and if you don’t, get clarification before you accept the financing. The SBA warns small business owners to watch for predatory lending warning signs, including interest rates significantly higher than competitors’ rates and fees above 5% of the loan value.

Build reputation signals: Lenders may look beyond your credit reports and take into account factors like customer reviews, your website and social media presence — even whether you use a dedicated business phone number and business email address. Some lenders will only extend credit to businesses with a formal business entity (LLC or corporation) because they consider sole proprietorships too risky. 

Bottom line

Credit risk is fundamental to small business lending. It can either work for you or against you as a business owner and borrower. 

For lenders, credit risk determines who gets approved, for how much, and at what interest rate. For borrowers, your credit risk profile will often determine whether you can get a loan or financing, how much you’ll pay, and the terms you’re offered. 

The good news is you can impact how risky your business appears to lenders by building a solid reputation, financially and with your customers and clients. The sooner you take those steps, the sooner you will be able to leverage your risk profile to your advantage. 

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