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, a corporation, a state or provincial authority, or a sovereign government.
Individual credit is scored by credit bureaus such as Experian, Equifax, and TransUnion on a three-digit numerical scale using a form of Fair Isaac Corporation (FICO) credit scoring. Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as S&P Global, Moody’s, or Fitch Ratings. These rating agencies are paid by the entity that is seeking a credit rating for itself or one of its debt issues.
- 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.
- Credit ratings determine not only whether or not a borrower will be approved for a loan or debt issue but also 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, a corporation, a state or provincial authority, or a sovereign government.
- Individual credit is rated on a numeric scale based on the FICO calculation; bonds issued by businesses and governments are rated by credit agencies on a letter-based system.
Understanding Credit Ratings
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 strong 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 and receiving favorable terms for that loan.
Credit ratings and credit scores
Credit ratings apply to businesses and governments—sovereign credit ratings apply to national governments, for example, while corporate credit ratings apply solely to corporations. Credit scores, on the other hand, 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 (see more under "Factors Affecting Credit Ratings and Credit Scores").
A short-term credit rating reflects the likelihood that a borrower will default 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. S&P Global, 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 junk bond, which means it is more likely to default on loans.
A Brief 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—that is, bonds with low credit ratings.The aim was 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, S&P Global, and Fitch Ratings—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 1923 Fitch developed and introduced the AAA through D rating system that has become the basis for ratings throughout the industry.
In the late 1990s, with plans to become a full-service global rating agency, Fitch Ratings 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 started to develop operating subsidiaries specializing in enterprise risk management, data services, and finance-industry training with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Learning.
Moody’s Investors Service
John Moody and Company first published “Moody’s Manual of Industrial and Miscellaneous Securities” 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’s Investors 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 began rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today.
Henry Varnum Poor first published the “History of the Railroads and Canals of the United States” in 1860, the forerunner of securities analysis and reporting that developed over the next century. The Standard Statistics Bureau, formed in 1906, published corporate bond, sovereign debt, and municipal bond ratings. Standard Statistics merged with Poor’s Publishing in 1941 to form Standard & Poor’s Corporation.
Standard & Poor’s Corporation was acquired by the McGraw-Hill Companies, Inc., in 1966, and in 2016 the company rebranded as S&P Global. It has become best known for indexes such as the S&P 500, introduced in 1957, a stock market index that is both a tool for investor analysis and decision-making and a U.S. economic indicator.
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, as 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 determines not only 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. As 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. One's credit rating should play a role in determining which lenders to apply to for a loan. The right lender for someone with great credit likely will be different than for someone with good or even poor credit.
Credit ratings also play a large role in a potential investor’s decision 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 by Standard & Poor’s, which reduced the country’s rating from AAA (outstanding) to AA+ (excellent) on Aug. 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 viewed as positively as another entity with equally good credit but a longer history. Debtors want to know a borrower can maintain good credit consistently over time. Considering how important it is to maintain a good credit rating, it's worth looking into the best credit monitoring services and perhaps choosing one as a means of ensuring your information remains safe.
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 Aug. 5, 2011. Global equity markets plunged for weeks following the downgrade.
Factors Affecting Credit Ratings and Credit Scores
Credit agencies take into consideration several factors when assigning a credit rating to an organization. First, an 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, a high numerical credit score from the credit-reporting agencies indicates a stronger credit profile and will generally result in lower interest rates charged by lenders. A number of factors are taken into account for an individual’s credit score, some of which have greater weight than others. Details on each credit factor can be found in a credit report, which typically accompanies a credit score.
These five factors are included and weighted to calculate a person’s FICO credit score:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Types of credit (10%)
As noted above, FICO scores range from a low of 300 to a high of 850—a perfect credit score that is achieved by only about 1% of the populace. Generally, a very good credit score is one that is 740 or higher. This score will qualify a person for the best interest rates on a mortgage and most favorable terms on other lines of credit. With a credit score that falls between 580 and 740, financing for certain loans can often be secured but with interest rates rising as the credit score falls. 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 one's 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.