Credit Default Risk – Definition & Explanation

The credit default risk is a latent financial risk of the lender to get the money lent as loan or loan only partially, not on time until not repaid at all.

The risk of a possible loan default begins with the transfer of the loan amount to the borrower. As of now, the lender is a creditor. A contract has been signed for the granting of the loan. The lender has fulfilled its essential part of the contract by paying the loan to the borrower. Now the debtor is on the move to repay the loan for a number of years in accordance with the contract. The repayment amount consists of the loan and the agreed loan interest.

They are the profit of the credit business for the bank. If the interest is not or only partially paid, then that reduces the merit. If, on the other hand, the borrowed loan is repaid only partially or not at all, ie repaid, then this is a loss of credit for the Bank or Sparkasse. She gets paid less money than she lent. To minimize or even eliminate such credit risk, credit institutions have three main mechanisms within their own lending policies.

That’s the ones

  • credit check
  • credit protection
  • credit insurance

Creditworthiness for secured loan repayment

Creditworthiness for secured loan repayment

A credit rating is the economic capacity of the borrower to be able to repay the loan according to the contract from his current income. A basis for credit rating is the credit bureau score. It is the mathematical summary of all positive and negative entries on those financial liabilities that are registered in the credit bureau database as information. The score is expressed in percentage points and is better the closer it gets to one hundred percent. Equally important is the contractually secured monthly income.

Revenues and expenditures are compared to determine what is the “free top”, that is, the non-committed income that exceeds expenditure. On the basis of general experience and the individual situation of the loan seeker his credit rating is evaluated. The computer programs of the banks take into account a variety of factors that the client advisor can not always comprehend in detail. It shows the creditworthiness of the applicant as a result of the credit check, namely for a credit-based loan together with the calculated effective interest rate.

Credit secured by land registry

Credit secured by land registry

A long-term and high six-digit loan such as a home loan is secured by a land registry. The creditworthiness of the client is sufficiently good. However, over the course of several decades, situations may arise in which the construction loan, it is said, can no longer be operated in the long term. The loan entitlement remains, even though the borrower does not fulfill the contract. This can be due to both private and economic reasons.

The latent loan default risk is now becoming current. The lender makes every effort to balance the current loan balance. For this he has the opportunity to foreclosure of the property due to the loan collateral. From the proceeds of the auction, the first-rate secured construction loan will be “served”. In order to get the disbursed loan repaid at a current balance that is as short as possible, the market value of the real estate is not lent entirely, but only proportionally.

A building loan in the amount of sixty to seventy percent of the real estate value is usual. A compulsory auction as the least favorable option, according to experience, brings a significantly lower revenue than a free real estate sale. With the land register entry as loan guarantee the credit default risk is largely neutralized.

Term life insurance for the client

Term life insurance for the client

In the case of a disease-related demise, or in the event of a sudden accidental death of the client as the main earner, the credit default risk becomes a hot topic from one day to the next. Apart from a suicide by the borrower, nobody has caused or caused this situation. In the interests of both sides, ie the lender and the borrower, a corresponding term life insurance is taken out at the same time as the contract for the construction loan and assigned to the bank. If the borrower dies as insured, then the life insurance sum is due. The open loan balance is cleared and the mortgage entered for the loan guarantee is deleted. The property is immediately debt free, so the heirs can freely dispose of it.

A credit default risk can not be avoided one hundred percent, but secured to nearly one hundred percent. Each lender is anxious to secure the loan, that is, the money lent as well as possible against a default. As a result, the costs incurred by the borrower make the loan more expensive with its loan amount and the loan interest.

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