A high-risk borrower is someone who a lender or creditor would consider more likely to default on his or her loan. High-risk borrowers have certain characteristics in common. But before we get into those, there's something to consider regarding borrowing money in general.
Good Debt vs. Bad Debt
It's important to know the difference between "good" debt and "bad" debt.
Generally, "good" debt provides you with benefits that outlast the payments. For instance, the benefits from a home loan or college loans can definitely outweigh the drawback of temporary payments.
"Bad" debt is the other side of the coin - when debts end up costing more than you can repay on time or whose costs outweigh their benefits. Examples of bad debt include: high-interest credit cards, payday loans, and loans for non-essential items that depreciate over time such as expensive cars and high-tech audio equipment.
You might want to take a look at your current debt and determine if it's "good" debt, "bad" debt or a mixture of both.
The Top 4 Characteristics of a High-Risk Borrower
A FICO® Score below 620. One of the first items a creditor or lender will examine to determine your creditworthiness (degree of risk) is your credit score. Since 90% of top lenders use FICO® Scores, which range from 300 - 850, they'll be looking for a score above 620 - especially for a conventional mortgage loan. Consumers with higher credit scores show a greater ability to make payments on time and have low credit utilization. On the other hand, risky borrowers tend to have lower credit scores, which reflect an ability to pay back loans and have high credit utilization.
Unusual employment status. An unusual employment status is not the same thing as an employment "change". Changing jobs is no longer an impediment to getting a mortgage, it's more your employment status that can make you appear (or not) like a risky borrower. Are you a 40-hour per week employee with a steady paycheck? Creditors prefer that. However, an unusual employment status may exist if you're a part-time worker or are self-employed with less than two years' worth of tax returns to verify your income, most lenders may hesitate to offer you credit.
No down payment. Lenders prefer that borrowers have some "skin in the game", and have an investment in their home from the outset. Typically, if you don't have a down payment (or have less than 20% of the purchase price for the down payment), you'll go through a more rigorous approval process, probably pay a higher interest rate and also pay mortgage insurance. The fact that a borrower doesn't have a down payment is a sign of risk and indicates higher potential that the person borrowing money won't be able to make their payments.
Dodging current financial responsibilities. Any kind of payment delinquency, from credit cards and tax liens to child support or federal student loans, increases the perception of risk. If you're not fulfilling the financial responsibilities you already have, why would the lender think you'd repay the debt your requesting this time around?
Another characteristic of a high-risk borrower (but not in the top 4) includes student loans that use deferments or forbearance (delaying payments). It's not the fact that you have student loans that make you a high-risk borrower, it's the fact that repayment is imminent. Even though you might be getting short-term relief, interest may continue to accrue, adding more of a financial obligation to the original loan you're already having trouble paying off.
So after reading about what makes a borrower appear risky, how do you think you'd appear to a creditor? High risk? Medium risk? Low risk? It's important to know the answer to that question before applying for a loan. That way you won't be surprised at the outcome.
*See how people once considered a "high-risk" borrower have worked to turn that perception around. Check out the myFICO forum anytime, from anywhere. *
Rob Kaufman
Rob is a writer... of blogs, books and business. His financial investment experience combined with a long background in marketing credit protection services provides a source of information that helps fill the gaps on one's journey toward financial well-being. His goal is simple: The more people he can help, the better.
Am I a high-risk borrower? Lenders consider those with bad credit (or no credit) to be high-risk. That's because they either don't have a proven track record to show that they are responsible borrowers, or they've had trouble repaying their debts.
High-risk mortgages often come with higher interest rates and larger monthly payments than traditional mortgages. This means that you will end up paying more in interest over the life of the loan, which can make it harder to pay off the mortgage and can put a strain on your finances.
Interest rates are a function of risk of default and opportunity cost. Longer-dated loans and debts are inherently more risky, as there is more time during which the borrower can default.
The term “high risk” is used by banks who provide merchant accounts for qualified businesses. They use this classification as a standard to hedge risk and anticipate common situations that occur with these types of businesses. Each industry has its own challenges.
Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original terms. To assess credit risk on a consumer loan, lenders often look at the five Cs of credit: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
Those with credit scores from 580 to 669 are generally seen as “subprime borrowers,” meaning they may find it more difficult to qualify for better loan terms. Those with lower scores – under 580 – generally fall into the “poor” credit range and may have difficulty getting credit or qualifying for better loan terms.
With their changing interest rates, adjustable-rate mortgages (ARMs) are a particularly risky choice for borrowers with less-than-ideal financial situations. In fact, some fixed-rate mortgages can also be problematic under the wrong circ*mstances.
Called the five Cs of credit, they include capacity, capital, conditions, character, and collateral. There is no regulatory standard that requires the use of the five Cs of credit, but the majority of lenders review most of this information prior to allowing a borrower to take on debt.
Answer: In situations with high risks, credit might create further problems for the borrower. Taking credit includes a borrower borrowing money from a lender at a high-interest rate. If the borrower is unable to repay the debt because of a loss in his work or business, he will slip even deeper into the loan trap.
Payments accepted online, over the phone, and through email are all examples of card-not-present transactions. Because it's easier for fraudsters to use stolen credit card numbers when they don't have to show a physical card, this type of payment is considered a high-risk transaction.
Higher- risk consumer loans are defined as all consumer loans where, as of origination, or, if the loan has been refinanced, as of refinance, the probability of default within two years is greater than 20 percent, excluding those consumer loans that meet the definition of a nontraditional mortgage loan.
Students classify those characteristics based on the three C's of credit (capacity, character, and collateral), assess the riskiness of lending to that individual based on these characteristics, and then decide whether or not to approve or deny the loan request.
Those with lower scores – under 580 – generally fall into the “poor” credit range and may have difficulty getting credit or qualifying for better loan terms.
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