The third in our series on financial literacy and understanding personal loans, this post will cover credit risk. Why is credit risk important? Well it is important to understand that loans have some risks for both the borrower and lender. The borrower takes on the obligation of paying back the loan while the lender takes on the risk of the borrower’s non-payment.
How to Assess Credit Risk for Personal Loans
When applying for a loan, developing your budget so that you know if you can afford a loan is critical. From there, looking at a series of factors can be helpful in determining the risk of a loan. For instance, looking at Ability to Repay (ATR). ATR analysis is often based on your DTI – debt to income ratio (your expenses compared to your income). Start by making a list of all of your recurring monthly expenses (such as your rent or mortgage, your car payment, etc.). Then, add in your take home pay from work and any other sources of income. By testing the DTI, both you and a lender can understand if you can afford the payment.
Like factoring in your DTI, using a lender that checks your credit report is important. By checking the credit report, the lender and the borrower can both be sure to know the full picture of the borrowers credit profile. You will also want to look at the payment amounts and terms. As we have written before, installment loans are easier to budget because they have a fixed payment amount. That is, you can budget in the same payment amount every month and know if you can afford the payment. Compare that to a credit card where you have to make a minimum monthly payment which changes over time.
Learn More About Credit Risk
The American Financial Services Association created Personal Loan
s 101: Understanding Credit Risk to help you better understand the risks on both sides associated with loans. Use this resource before entering into a personal loan to make sure you understand your obligations.