Credit Risk Problems

Credit risk is a problem for both consumers and lenders. If a consumer is deemed a credit risk, he will encounter widespread financial problems that hurt his personal finances. If a financial institution grants too much credit to unworthy borrowers, its business suffers. As of 2010, total individual debt in the United States is up to $2.46 trillion, according to the Federal Reserve.

Definition

A high credit risk is a term used by banks to connote when a borrower is unlikely to pay back a debt. In consumer's terms, if you are considered a credit risk, you usually have insufficient or poor credit history. A potential lender determines riskiness by reviewing your credit report and credit score, which list information about your account history, credit to debt ratio, payment history and more.

History

Before communication and computers came onto the scene, a person's credit worthiness was determined by word of mouth. In the 20th century, credit bureaus began to form -- including today's three most well known, Experian, Equifax and TransUnion -- and these bureaus collected credit information to provide to potential lenders. In 1971, the Fair Credit Reporting Act was passed, requiring reports to include positive information rather than just negative behaviors. This act also allowed consumers to view their own reports, which you can now do online.

Significance

Potential lenders must analyze your credit risk because they are essentially giving you money for nothing in return, and they need to know how likely it will be that you will be able to pay it back. If a bank doesn't constantly monitor credit risk, it runs the risk of losing capital and even going out of business.

Effects on Consumers

If you are considered a high risk to lenders, you may encounter a number of difficulties. First, your credit cards or loans may have high APRs, meaning you will be required to pay more interest on balances. Also, your credit limit may be set lower than it would be if you had good credit. If you have mismanaged your credit or lack a credit history, obtaining a mortgage or car loan can be incredibly difficult. It may even be difficult to be approved for an apartment, phone contract or occasionally a job if you are a high credit risk.

Prevention/Solution

Though it won't happen overnight, it is possible as a consumer to transition from being a credit risk to being credit worthy. The Federal Trade Commission recommends paying your bills on time, paying down outstanding debts and avoiding new debt. Enrolling in a debt repayment plan may help you meet your goals, but if you prefer not to pay for assistance, focus on paying down your debts in descending order starting with the debt with the highest interest rate.