Credit Rating

AAA

DEFINITION of 'Credit Rating'

An assessment of the credit worthiness 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. Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as Standard & Poor’sMoody’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.

VIDEO

Loading the player...

BREAKING DOWN 'Credit Rating'

For individuals, credit ratings are derived from the credit history maintained by credit-reporting agencies such as Equifax (EFX), Experian, and TransUnion (TRU).

A loan is essentially a promise, and a credit rating determines the likelihood that the borrower will 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. Similarly, sovereign credit ratings apply to national governments, and corporate credit ratings apply solely to corporations.

Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA (excellent) and AA+ all the way to C and D. A debt instrument with a rating below BBB- is considered to be 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 borrower 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 the interest rate at which the loan will need to be repaid. Since companies depend on loans for many start-up 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 buyer'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 not pay off its bonds. For more on why a high credit rating is essential for a business, read The Importance Of Your Credit Rating.

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 newest data, and one negative debt will bring down even the best score. Credit also takes time to build up. If an entity has good credit but a short credit history, that isn't seen as positively as the same quality of credit but with a long history. Debtors want to know a borrower can maintain good credit consistently over time.
 
Credit rating changes can have a significant impact on financial markets. A prime example of this effect is the adverse market reaction to the credit rating downgrade of the U.S. federal government by Standard & Poor’s on August 5, 2011. Global equity markets plunged for weeks following the downgrade.

Factors Affecting Credit Ratings and Credit Scores

There are a few factors credit agencies take into consideration when assigning a credit rating for 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 repo​rt, which typically accompanies a credit score. For a more detailed description of each credit factor, read The 5 Biggest Factors That Affect Your Credit.

Short-Term vs. Long-Term Credit Ratings

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.

History of Credit Ratings

Moody's was the first agency to issue publicly available credit ratings for bonds, in 1909, and other agencies followed suit in the decades after. These ratings didn't have a profound effect on the market until 1936, when a new rule was passed that prohibited banks from investing in speculative bonds, or those with low credit ratings, to avoid the risk. This practice was quickly adopted by other companies and financial institutions, and relying on credit ratings became the norm.

RELATED TERMS
  1. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  2. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  3. Jamming

    A scam perpetrated by bogus credit repair firms that involves ...
  4. Semi-Secured Credit Card

    A type of credit card offered to individuals who carry a higher ...
  5. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  6. Credit Freeze

    A credit freeze, also called “security freeze,” is a freeze on ...
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Short Term Hi Yld Bd

    Find out about the SPDR Barclays Short Term High Yield Bond ETF, and explore detailed analysis of the fund that tracks short-term, high-yield corporate bonds.
  3. Investing Basics

    What Is A Corporate Credit Rating?

    Is the bond you're buying investment grade, or just junk? Find out how to check the score.
  4. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  5. Personal Finance

    The Debt Ratings Debate

    Lack of competition and potential conflicts of interest have called the value of these ratings into question.
  6. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  8. Credit & Loans

    Can Corporate Credit Cards Affect Your Credit?

    Corporate cards have a hidden downside. If the company fails to pay its bills, you could be liable for the amount and end up with a damaged credit rating.
  9. Credit & Loans

    Millennials Guide: Picking the Best Rewards Cards

    There are perks a-plenty on offer, but you have to find the right plastic for your lifestyle.
  10. Mutual Funds & ETFs

    ETF Analysis: First Trust Tactical High Yield

    Find out more about the First Trust Tactical High Yield fund, a debt security-focused ETF designed to produce high income.
RELATED FAQS
  1. What's the difference between a credit rating and a credit score?

    Although credit rating and credit score may be used interchangeably in some cases, there is a distinction between these two ... Read Full Answer >>
  2. What do the letters / symbols on credit ratings mean?

    The letters or numbers used to express a credit rating or credit score express the creditworthiness of the individual, business ... Read Full Answer >>
  3. Does a good credit rating guarantee repayment?

    An issuer's credit rating cannot guarantee repayment of any debt obligation, but it can give investors a good idea of the ... Read Full Answer >>
  4. Why would someone change their Social Security number?

    In general, the Social Security Administration, or SSA, does not encourage citizens to change their Social Security numbers, ... Read Full Answer >>
  5. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  6. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bear Market

    A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment ...
  2. Alligator Spread

    An unprofitable spread that occurs as a result of large commissions charged on the transaction, regardless of favorable market ...
  3. Tiger Cub Economies

    The four Southeast Asian economies of Indonesia, Malaysia, the Philippines and Thailand. Tiger cub economy indicates that ...
  4. Gorilla

    A company that dominates an industry without having a complete monopoly. A gorilla firm has large control of the pricing ...
  5. Elephants

    Slang for large institutions that have the funds to make high volumes trades. Due to the large volumes of stock that elephants ...
  6. Widow's Exemption

    In general terms, a widow's exemption refers to the amount that can be deducted from taxable income by a widow, thereby reducing ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!