In the world of finance, we hear the term “credit rating” in many different contexts. It’s important to know what credit rating are and how they apply to financial transactions between individuals, companies, and governments.
A credit rating applies to any party that is seeking to borrow money. This can be a business, an individual, or even a government, although when applying to an individual, it is referred to as a credit score (derived from a credit report).
Individual credit scores are maintained by companies such as Equifax, Experian, and TransUnion. These evaluate the likelihood that an individual is going to pay back the money that they are loaned over time. In other words, it assesses their creditworthiness.
The companies mentioned above determine a credit score by systematically sorting through an individuals credit files and analyzing them for any reason why you might have trouble covering the return payments of a loan among other things.
How Useful is a Credit Score?
When entering into a loan as a borrower, you are contractually (legally) bound to the terms of that agreement. Failing to repay the loan on the determined schedule, for example, will result in a default on the loan.
For a lender, the credit score is a vital tool for evaluating risk in the process of due diligence. It places all borrowers on a level playing field so that a lender can match his or her risk preference with appropriate borrowers.
Credit scores are also important when buying a house or a car (unless you pay for it all upfront with cash). Banks look seriously at credit reports (among other things) when you apply for a mortgage.
Most people know their own credit score as a single number. This most likely your FICO score which is based on a particular risk assessment model developed by FICO in 1989. These scores range from 300 – 850, the higher the better.
In April 2017, FICO reported that average FICO scores in the U.S. had reached an all-time high at 700. Having a credit score below 600 is consider to be “bad credit”.
Having a high FICO score helps with a large number of things. A stellar score will place you in a bracket that earns the best deals on loans, maybe a low interest rate on a car loan or credit card payments. Being in a lower bracket may prevent you from getting a loan at all.
FICO outlines their measurement metrics here. As you can see, 35% of the score depends upon how quickly and regularly you pay off debts. Another 30% is calculated by measuring the amount that you still owe.
Not everyone has a credit score right away. It is important to apply for things that build credit as early as possible so that you begin to establish a history that spans a long time. FICO places another 10% of your credit score on the longevity of your credit history.
Unlike with individuals, businesses, entities, and governments have credit ratings. In essence both a credit score and a credit rating refer to the same thing (the creditworthiness of a borrower), but they are measured differently and by different organizations.
Here is a chart outlining the grading scale that is used by each firm. (Source)
You may remember in 2011, S&P downgraded the U.S. economy from AAA to AA+. Read this for overview of that decision.
The ramifications of such a rating change are potentially far reaching. In this case, a large part of the decision was influenced by political factors after lengthy discussions occurred between the White House administration and S&P.
As you can imagine, these calculations are far more complicated and qualitative than individual credit scores even though they serve roughly the same purpose.
Governments need to be rated just as much as individuals and companies, because they need to borrow money for many different types of things. When a government needs to raise money, they issue bonds.
Bonds are the most common way to lend money to the government. The U.S. has enjoy a great credit rating (AAA) for 70 years which is what made U.S. treasury bonds one of the safest investments you can make. Not much has changed. The only way that you would not be paid back for your investment is it the government defaults.
In regards to bonds, risk is calculated a number of ways. Read this for 6 different types of risk associated with bonds.
Bonds are also preferred by many investors because a bond holder has priority over a share holder in a company’s repayment plan (and in the case of defaults). This makes them a less risky way to invest in a company.
Just how risky? Head over to S&P and do some research.