Updated: Mar 4, 2020
"A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation."
What Is a Credit Rating?
A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money—an individual, corporation, state or provincial authority, or sovereign government.
An individual credit is scored from credit bureaus such as Experian and TransUnion on a 3-digit numerical scale using a form of Fair Isaac (FICO) credit scoring. Credit assessment and evaluation for companies and governments are generally done by a credit rating agency such as Standard & Poor’s (S&P), Moody’s, or Fitch. These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.
How Does Credit Rating work?
A loan is a debt—essentially a promise, often contractual, and a credit rating determines the likelihood that the borrower will be able and willing to pay back a loan within the confines of the loan agreement, without defaulting. A high credit rating indicates a high possibility of paying back the loan in its entirety without any issues; a poor credit rating suggests that the borrower has had trouble paying back loans in the past and might follow the same pattern in the future. The credit rating affects the entity's chances of being approved for a given loan or receiving favorable terms for said loan.
Credit ratings apply to businesses and government, while credit scores apply only to individuals. Credit scores are derived from the credit history maintained by credit-reporting agencies such as Equifax, Experian, and TransUnion. An individual's credit score is reported as a number, generally ranging from 300 to 850. Similarly, sovereign credit ratings apply to national governments, while corporate credit ratings apply solely to corporations.
A short-term credit rating reflects the likelihood of the borrower defaulting within the year. This type of credit rating has become the norm in recent years, whereas in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower's likelihood of defaulting at any given time in the extended future.
Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB is considered to be a speculative-grade or a junk bond, which means it is more likely to default on loans.
Why Credit Ratings Are Important?
Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies. While a borrowing entity will strive to have the highest possible credit rating since it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service/repay the debt.
A credit rating not only determines whether or not a borrower will be approved for a loan but also determines the interest rate at which the loan will need to be repaid. Since companies depend on loans for many start-ups and other expenses, being denied a loan could spell disaster, and a high-interest rate is much more difficult to pay back. Credit ratings also play a large role in a potential investor's determining whether or not to purchase bonds. A poor credit rating is a risky investment; it indicates a larger probability that the company will be unable to make its bond payments.
Factors Affecting Credit Ratings and Credit Scores
There are a few factors credit agencies take into consideration when assigning a credit rating to an organization. First, the agency considers the entity's past history of borrowing and paying off debts. Any missed payments or defaults on loans negatively impact the rating. The agency also looks at the entity's future economic potential. If the economic future looks bright, the credit rating tends to be higher; if the borrower does not have a positive economic outlook, the credit rating will fall.
For individuals, the credit rating is conveyed by means of a numerical credit score that is maintained by Equifax, Experian, and other credit-reporting agencies. A high credit score indicates a stronger credit profile and will generally result in lower interest rates charged by lenders. There are a number of factors that are taken into account for an individual's credit score including payment history, amounts owed, length of credit history, new credit, and types of credit. Some of these factors have greater weight than others. Details on each credit factor can be found in a credit report, which typically accompanies a credit score.
Five factors are included and weighted to calculate a person's FICO credit score:
35%: payment history
30%: amounts owed
15%: length of credit history
10%: new credit and recently opened accounts
10%: types of credit in use
FICO scores range from a low of 300 to a high of 850—a perfect credit score that is achieved by only 1% of consumers. Generally, a very good credit score is one that is 720 or higher. This score will qualify a person for the best interest rates possible on a mortgage and the most favorable terms on other lines of credit. If scores fall between 580 and 720, financing for certain loans can often be secured, but with interest rates rising as the credit scores fall. People with credit scores below 580 may have trouble finding any type of legitimate credit.
It is important to note that FICO scores do not take age into consideration, but they do weight the length of credit history. Even though younger people may be at a disadvantage, it is possible for people with short histories to get favorable scores depending on the rest of the credit report. Newer accounts, for example, will lower the average account age, which could lower the credit score. FICO likes to see established accounts. Young people with several years worth of credit accounts and no new accounts that would lower the average account age can score higher than young people with too many accounts, or those who have recently opened an account.
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