Credit rating is the means of assessing the creditworthiness of individuals, companies, states, and countries. It indicates the ability of the debtor (individual, company, state, or country) to fulfill his financial commitments. Credit rating can refer to personal, corporate, or sovereign.
Personal Credit Rating
In the US, creditors use a scale of 0 to 9 in order to rank a debtor. The numbers can be preceded by the alphabets R or I. I refers to credit that is repaid in installments (like mortgage on a house), while R refers to a system of revolving credit (credit cards), whereby the debtor is only required to make minimum monthly payments. R1/I1 means that the debtor repays his debt in one month, while R2/I2 means that he repays within 2 months. R7/I7 indicates a situation wherein debts are paid by consolidation. R8/I8 implies that debts are recovered by repossession. R9/I9 is the worst rating and indicates the inability to repay debts.
Credit Report and Credit Score
Information about credit inquiries, bankruptcies, liens, judgments, or collections is sent to the credit bureaus, which prepare an individual's credit report, and assign credit scores. A person has 3 credit scores assigned to him by the following bureaus: Equifax, Experian, and TransUnion. While these scores may differ, the underlying principal is the same. The credit bureaus calculate scores based on the credit scoring system created by the Fair Isaac Corporation (FICO) in the year 1958.
Credit scores computed by Experian are called 'FICO or FICO II', scores calculated by TransUnion are called 'Empirica', and credit rating computed by Equifax are called 'Beacon'. Fair Isaac Corp. has also developed the next generation FICO scores, which are meant to be user-friendly. The FICO advanced risk score is used by Experian, while TransUnion uses Precision, and Equifax uses Pinnacle, to calculate credit scores. Credit bureaus also assigns weightage to the following factors while calculating credit scores: 35% to previous credit performance, 30% to current indebtedness, 15% to the use of time credit, 15% to the types of credit available, and 5% to new credit.
FICO scores are fast gaining popularity over the R/I multiple rating system. Hence, we can discuss the importance of good personal credit rating from the perspective of maintaining good FICO scores.
Good Credit Rating for an Individual
Credit ratings for an individual range between R0/I0 and R9/I9. The worst rating is 9, while 0 would mean that a person has no credit history. Credit scores for an individual are generally in the range of 360 and 850. A score below 620 is considered unhealthy. The worst score, of course, is 360 and the best is 850. Higher the credit score, lower the risk of a person defaulting. A poor credit score would result in lenders charging a premium for providing loans. If the credit score is very poor, lenders may refuse to provide credit. A credit score between 650 and 690 is considered good, while a score above 700 is considered optimal by lenders.
Corporate Credit Rating
Corporate credit scores are assigned by independent credit rating providers like Moody's, Standard and Poor's, and Fitch. These ratings are used to determine the rate of default on bonds or corporate debt. Bondholders are the creditors of the company. Higher the rate or chance of default, lower the rating. AAA, AA, A, BBB, BB, B, CCC , CC, C, and D are the ratings for Standard and Poor's (S&P's), while the rating scale for Moody's is: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, and C. Fitch's rating scale is similar to that of S&P's.
Good Credit Rating for a Company
The best rating for a company's bonds according to S&P's is AAA (Aaa for Moody's). Bonds with ratings Baa3 (BBB for S&P's) and higher are known as investment grade bonds. A bond with rating lower than Baa3 (BBB for S&P's) is considered a speculative or a junk bond. A company whose bonds carry a poor rating would be forced to pay a higher yield on the bonds, in order to compensate the creditors for the risk undertaken by them.
Sovereign Credit Rating
Sovereign credit rating is the rating assigned to a country. It determines the risk involved in investing in a country. This rating is based on both political and economic factors. Political instability and a country's inability or unwillingness to repay its debts, would result in a poor credit score. Moody's, Standard and Poor's, and Fitch all provide country ratings. They also provide credit ratings for states within the US.
Good Credit Rating for a Country/State
The ratings for countries and states are similar to those of corporates. California's credit rating, according to Moody's, is A2, which is just 5 notches above the junk/high risk rating. On June 19, 2009, Moody's warned of a possible downgrade due to rising state deficit. A downgrade would increase the cost of borrowing for the state.
S&P's has recently downgraded Ireland's credit rating from AAA to AA. S&P's felt that Ireland's fiscal deficit was going to increase because of the high cost of supporting the Irish banking system. The Irish government would also be forced to carry a significant debt burden because of the same reason. These factors have resulted in lowering the credit scores of the country, since the country's investing environment has become riskier than before.
A good credit rating is important for all entities. For corporates, countries and states, a good credit rating would encourage investments whereas in case of individuals, it would mean lower borrowing costs.