Credit ratings are essential grading systems that help an entity when applying for a credit card or loan.
Understanding the basics of how your credit is rated will allow you to get an insight into your credit health and how likely you are to be approved for a loan.
What Is a Credit Rating?
A credit rating often expressed via a letter grade, is an evaluation conducted by a credit agency to determine the ability and willingness of a business, government, or individual to fulfill their financial obligations in a complete and timely manner.
Since a loan usually is a contractual debt, credit rating essentially serves to identify the likelihood that the person borrowing money will be able to pay back that loan within the mutual agreement, and without defaulting.
In this regard, a high credit rating communicates a strong possibility of the loan being paid entirely and without any issues. On the other hand, a low credit rating displays that the person involved has had trouble paying back their loans.
This also signifies they may follow the same pattern with future loans. Accordingly, the credit rating will affect whether an entity is approved for receiving a loan. In most cases, it can dictate how favorable the terms of the loan are as well.
What Is the Difference Between Credit Rating and Credit Score?
While credit ratings are used to evaluate an entity’s creditworthiness, i.e. a government, business, corporation, or sovereign country, a credit score is exclusive to individuals only in identifying their personal credit health.
In case the entity is asking for a loan, their credit rating will determine whether they will be issued that loan in the first place. In case of a favorable outcome, then the credit rating helps guide the terms of the loan (interest rate, repayment dates, etc.). Credit ratings are also essential for bond issuances and allow investors to decide whether they want to invest their money in the bond or not.
On the other hand, credit scores are used by credit card companies, banks, and other loan institutions that serve individuals. They indicated whether a person will be able to honor the terms of the loan including the repayment dates and interest rates.
How Is Your Credit Rating Evaluated?
There are a few factors that come into play when evaluating an entity’s credit rating. First, the agency doing the rating takes into account the entity’s history of taking loans and paying debts. If there are any defaults or missed payments, this will negatively affect the credit rating. Moreover, the agency also considers the economic future of the entity. Other data may be sourced from the entity’s annual reports, audited financial statements, as well as analyst reports, published news articles, and industry projections.
The more promising that future is, the higher the credit rating will be, and vice versa. Meanwhile, the credit rating of an individual is often conveyed via a numerical credit score communicated by credit-reporting agencies.
A higher score often means a lower interest rate and better terms overall. As of today, there are three main credit agencies that control the majority of the rating market; Standard & Poor’s, Moody’s Investor Services, and Fitch Group. While these agencies use different rating systems to determine credit ratings, they do share some striking similarities.
The Different Types of Credit Rating
The three main credit agencies all have their respective terminology to determine credit ratings. With that said, the types of credit ratings tend to fall into these two categories.
- Investment Grade: this means the entity is likely to honor the terms and conditions of the loan. This is a solid investment for the rating agency and is, therefore, less competitively priced compared to speculative-grade investments.
- Speculative Grade: this means the investment is high risk for the credit agency, so the interest rates will reflect that.