What is a credit rating?
A credit score is a quantified assessment of a borrower’s creditworthiness in general terms or in relation to a particular debt or financial obligation. A credit rating can be assigned to any entity seeking to borrow money – an individual, a business, a state or provincial authority, or a sovereign government.
Individual credit is assessed by credit bureaus such as Experian and TransUnion on a 3-digit number scale using a form of Fair Isaac credit rating (FICO). Credit and evaluation for businesses and governments is usually done by a credit rating agency such as Standard & Poor’s (S&P), Moody’s or Fitch. These rating agencies are remunerated by the entity which seeks a credit score for itself or for one of its debt problems.
How the credit rating works
A loan is a debt – essentially a promise, often contractual, and a credit score determines the likelihood that the borrower will be able and willing to repay a loan within the limits of the loan agreement, without default. A high credit rating indicates a strong possibility of paying off the loan in full without any problem; a bad credit rating suggests that the borrower has struggled to repay their loans in the past and may follow the same pattern in the future. The credit rating affects the entity’s chances of being approved for a given loan or of receiving favorable terms for that loan.
Credit ratings apply to businesses and government, while credit ratings apply only to individuals. Credit ratings are derived from credit history maintained by credit reporting agencies such as Equifax, Experian and TransUnion. A person’s credit rating is shown as a number, usually between 300 and 850. Similarly, sovereign credit ratings apply to national governments, while corporate credit ratings apply only to companies. (For related reading, see “Credit Score vs. Credit Score: What’s the Difference?”)
A short-term credit rating reflects the likelihood of borrower default during the year. This type of credit rating has become the norm in recent years, when in the past, long-term credit ratings were more widely taken into account. Long-term credit scores predict the likelihood of borrower default at some point in the extended future.
Credit rating agencies generally assign scores to indicate the scores. Standard & Poor’s, for example, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a score lower than BB is considered a speculative rating or an undesirable bond, which means that ‘It is more likely to default on loans.
Key points to remember
- A credit score is a quantified assessment of a borrower’s creditworthiness in general terms or in relation to a particular debt or financial obligation.
- A credit score not only determines whether or not a borrower will be approved for a loan or debt issue, but also determines the interest rate at which the loan will be paid.
- A credit score or score can be assigned to any entity seeking to borrow money – an individual, a business, a state or provincial authority, or a sovereign government.
- Individual credit is evaluated on a numerical scale on the basis of the FICO calculation, bonds issued by companies and governments are rated by credit agencies according to a letter system.
A brief history of credit ratings
Moody’s published credit ratings for publicly available bonds in 1909 and other agencies followed suit in the decades that followed. These ratings did not have a profound effect on the market until 1936, when a new rule was adopted prohibiting banks from investing in speculative bonds, or bonds with low credit ratings, in order ” avoid the risk of default that could lead to financial losses. This practice was quickly adopted by other companies and financial institutions and, soon enough, the use of credit ratings became the norm.
The global credit rating industry is highly concentrated, with three agencies – Moody’s, Standard & Poor’s and Fitch – controlling almost the entire market.
John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics for use in the investment industry via “The Fitch Stock and Bond Manual” and “The Fitch Bond Book”. In 1924, Fitch introduced AAA through a D rating system which became the basis for ratings throughout the industry.
With the intention of becoming a full-service global rating agency, in the late 1990s, Fitch merged with IBCA of London, a subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings Co. Starting in 2004, Fitch began to develop operational subsidiaries specializing in enterprise risk management, data services and training in financial sector with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Training.
Moody’s Investor Service
John Moody and Company first published “Moody’s Manual “in 1900. The manual published basic statistics and general information on stocks and bonds in various industries. From 1903 until the stock market crash of 1907,” Moody’s Manual “was a national publication. In 1909, Moody’s began publishing “Moody’s Analyzes of Railroad Investments”, which added analytical information on the value of the securities.
Expanding on this idea led to the creation in 1914 of Moody’s Investors Service, which over the next 10 years would provide ratings for almost all government bond markets at the time. In the 1970s, Moody’s began to assess commercial paper and bank deposits, becoming the large-scale rating agency it is today.
Standard & Poor’s
Henry Varnum Poor published for the first time “The History of Railways and Canals in the United States” in 1860, the forerunner of the analysis and reporting of titles to be developed over the next century. Standard Statistics formed in 1906, which published the ratings of corporate bonds, sovereign debt and municipal bonds. Standard Statistics merged with Poor’s Publishing in 1941 to form Standard and Poor’s Corporation, which was acquired by The McGraw-Hill Companies, Inc. in 1966. Standard and Poor’s is best known by indices such as the S&P 500, a stock index which is both an analysis and decision-making tool for investors and an American economic indicator.
Why Credit Ratings Are Important
The credit ratings given to borrowers are based on significant due diligence conducted by the rating agencies. While a borrowing entity will strive to have the highest possible credit rating because it has a major impact on the interest rates charged by lenders, rating agencies must have a balanced and objective view of the borrower’s financial situation and ability to repay / repay the debt.
A credit score 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 have to be repaid. Since businesses depend on loans for many start-up and other expenses, refusing a loan could be catastrophic and a high interest rate is much more difficult to repay. Credit ratings also play an important role in determining whether a potential investor will buy bonds or not. Bad credit is a risky investment; this indicates a greater likelihood that the business will not be able to make its bond payments.
The US government’s credit rating according to Standard & Poor’s, which reduced the country’s rating from AAA (outstanding) to AA + (excellent) on August 5, 2020.
It is important for a borrower to remain diligent in maintaining a high credit rating. Credit ratings are never static; in fact, they change all the time based on the most recent data, and negative debt will drop even the highest score. Credit also takes time to build up. An entity with good credit but a short credit history is not viewed as positively as another entity with the same credit quality but a longer history. Debtors want to know that a borrower can maintain good credit steadily over time.
Changes in credit ratings can have a significant impact on the financial markets. A typical example is the unfavorable market reaction to the downgrade of the US federal government credit rating by Standard & Poor’s on August 5, 2020. World stock markets plunged for weeks after the downgrade.
Factors Affecting Credit Ratings and Scores
There are a few factors that credit reporting agencies take into consideration when assigning a credit rating to an organization. First, the agency takes into account the entity’s borrowing and debt repayment history. Any payment or default on loans has a negative impact on the rating. The agency is also examining 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 decline.
For individuals, the credit score is transmitted through a digital credit score which is maintained by Equifax, Experian and other credit reporting agencies. A high credit rating indicates a more solid 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 a person’s credit rating, including payment history, amounts owed, length of credit history, new credit, and types of credit. Some of these factors carry more weight than others. Details on each credit factor can be found in a credit report, which usually accompanies a credit score.
Five factors are included and weighted to calculate a person’s FICO credit rating:
- 35%: payment history
- 30%: amounts due
- 15%: duration of credit history
- 10%: new credit and recently opened accounts
- 10%: types of credits used
FICO scores range from a minimum of 300 to a maximum of 850, a perfect credit score that is only achieved by 1% of consumers. Generally, a very good credit score is one that is 720 or higher. This score will allow a person to benefit from the best possible interest rates on a mortgage and the most advantageous conditions on other lines of credit. If the ratings are between 580 and 720, the financing of some loans can often be guaranteed, but with interest rates that increase as the credit ratings drop. People with credit scores below 580 may find it difficult to find any type of legitimate credit.
It is important to note that FICO scores do not take age into account, but do weigh the length of the credit history. Even though the youngest may be disadvantaged, it is possible that people with a short history may get favorable scores based on the rest of the credit report. New accounts, for example, will lower the average age of the account, which could lower the credit score. FICO likes to see the accounts drawn up. Youth with multiple years of credit accounts and no new accounts that lower the average age of accounts can have a higher score than youth with too many accounts or those who have recently opened an account.