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.
Individuals' credit is scored from by 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 is 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 Credit Rating Works
A loan is a debt - it is 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 speculative grade or a junk bond, which means it is more likely to default on loans.(For information on bond ratings systems see Bond Ratings Agencies: Can You Trust Them.)
- 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 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 need to be repaid.
- A credit rating or score can be assigned to any entity that seeks to borrow money — an individual, corporation, state or provincial authority, or sovereign government.
- Individuals' credit is rated on a numeric scale based on the FICO calculation, bonds issued by businesses and governments is rated by credit agencies on a letter-based system.
History of Credit Ratings
Moody's issued 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 bonds with low credit ratings, to avoid the risk of default which could lead to financial losses. This practice was quickly adopted by other companies and financial institutions and, soon enough, relying on credit ratings became the norm.
The global credit rating industry is highly concentrated, with three agencies – Moody's, Standard & Poor's and Fitch – controlling nearly 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 the AAA through D rating system that has become the basis for ratings throughout the industry. With plans to become a full-service global rating agency, in the late 1990s Fitch merged with IBCA of London, subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings Co. Beginning in 2004, Fitch began to develop operating subsidiaries specializing in enterprise risk management, data services and finance-industrytraining with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Training.
Moody's Investors Service
John Moody and Company first published "Moody's Manual" in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash of 1907, "Moody's Manual" was a national publication. In 1909 Moody began publishing "Moody's Analyses of Railroad Investments," which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody'sInvestors Service, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at the time. By the 1970s Moody's had beuan rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today.
Standard & Poor's
Henry Varnum Poor first published the "History of Railroads and Canals in the United States" in 1860, the forerunner of securities analysis and reporting to be developed over the next century. Standard Statistics formed in 1906, which published corporate bond, sovereign debt and municipal bond ratings. 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 has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision-making, and a U.S. economic indicator. (See A Trip through Index History to learn more about Standard & Poor's indexes.)
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-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 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.
The credit rating of the U.S. government according to Standard & Poor's, which reduced the country's rating from AAA (outstanding) to AA+ (excellent) on August 5, 2011.
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. An entity with good credit but a short credit history is not seen as positively as another entity with the same quality of credit but a longer 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 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 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 which 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 mortgageand 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 in turn 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. (For additional reading, check out: How Can I Improve My Credit Score? )