What Is a Credit Rating?

Introduction

A credit rating is a numerical expression that determines the ability of a person or a business to pay back borrowed money, based on a person's or business’s credit history. It is a financial evaluation, used to measure a borrower's default risk on all types of debt, such as auto loans, mortgages, and credit cards.

Definition of Credit Rating

Credit ratings are usually assigned by specialized credit rating agencies that collect and analyze financial data related to the debt issuance of individual consumers and businesses. These ratings are assigned on a scale ranging from the highest AAA rating, down to D, the latter representing an uncovered debt with practically no chance of being repaid.

Purpose of a Credit Rating

Credit ratings are important to lenders, who use them to determine the ability of a borrower to pay back a loan. A credit rating is also used to set the interest rate for bonds issued by companies and corporations, or to determine the stability of potential investments.

How to Calculate Credit Ratings

A credit rating is an assessment of an individual’s creditworthiness. It provides lenders with an indication of the likelihood that a borrower will default on a loan. Credit ratings are calculated by credit rating agencies such as Standard & Poor’s, Fitch, and Moody’s. Understanding how to calculate credit ratings can help you assess your own financial profile and make wise financial decisions.

Step 1: Gather Credit Reports

The first step to calculating your credit rating is to gather your reports from the three major credit reporting bureaus: Equifax, Experian, and TransUnion. You can obtain these credit reports for free once a year at annualcreditreport.com. Each of these reports will contain your credit history and financial obligations such as credit card debts, loan payments, and the like. Collection agencies may also be listed on your credit report.

Step 2: Analyze Credit Reports

Once you have obtained your credit reports, you will need to analyze them to determine your creditworthiness. This involves looking at each report and assessing your payment history, account balances, and inquiries. Payment history is the most important factor in assessing creditworthiness as it reflects an individual’s ability to repay debts. Account balances will be used to compare how much debt a person has relative to their available credit. Inquiries are used to determine whether a person has been applying for numerous lines of credit.

Step 3: Evaluate Credit Score

After assessing your individual credit reports, you can calculate your credit score. There are different types of credit scores, but the most commonly used type is the FICO score. This score ranges from 300 to 850, with higher scores indicating better creditworthiness. The FICO score combines payment history, account balances, inquiries, and other factors to come up with an overall credit score. Different lenders have different minimum requirements for approving loans, so it is important to know your credit score.

Step 4: Generate a Credit Rating

Once you have determined your credit score, you can use this information to generate a credit rating. Generally, a credit score of 720 or higher can indicate good creditworthiness and a score below 680 can indicate poor credit worthiness. Different lenders may have different standards for credit ratings, so you should consult with a financial advisor to get a better understanding of how your credit score will affect your ability to borrow money or get approved for loans.

Knowing how to calculate credit ratings can help you make better financial decisions and understand how lenders may view your creditworthiness. After analyzing your credit reports and calculating your credit score, you can then generate a credit rating that can help lenders assess your ability to repay loans.

Different Types of Credit Ratings

Different credit rating scales measure the risk potential of potential borrowers and creditors. The most common types of credit ratings are:

FICO Scores

FICO (Fair Isaac & Co.) scores are probably the most widely used and recognized credit scores in use today. The FICO score assigns a numerical value to a person’s credit history and creditworthiness. Generally, the higher a person’s score, the better their credit profile is considered. FICO scores typically range from 300 to 850.

Vantage Scores

VantageScores are the competing score to FICO scores, developed by the three major credit bureaus. The score ranges from 501 to 990, with a higher score having positive implications on a borrower’s creditworthiness. The VantageScore is a newer score, and not yet as widely used, but offers a different point of view into a borrower’s credit profile.

Paydex Score

Paydex scores are offered by Dun & Bradstreet and range from 0 to 100. A Paydex score is a numerical representation of a person’s payment history and typically takes commercial relationships into account. Depending on a person’s credit history, this score can differ significantly from their FICO or Vantage score.

BEACON Score

Beacon scores are offered by Experian, and range from 0 to 990. This score is especially helpful for those who have a limited credit history, as the scores factor in rental payments and other payment behavior beyond the traditional credit rating criteria for credit cards and other types of debt. The higher the score, the better the expected credit behavior.

Credit Rating Classifications

A credit rating is the grade assigned to a person, corporation or government based on how likely they will be to fulfill their financial obligations. Depending on the organization, these ratings are on a tier system, with different grade levels representing the various levels of risk. These ratings are used by lenders to determine the amount of risk associated with a borrower and whether to issue them a loan.

Excellent

An excellent credit rating indicates that a person or entity is highly likely to pay back their debts in a timely fashion. Typically, those with an excellent credit rating have a credit score of 750 or higher on the FICO or VantageScore rating systems.

Good

Those with a good credit rating typically have a credit score between 700 and 749, indicating that the individual or entity is likely to make timely payments on their debt. A good credit score is considered a good indicator for lenders to look at.

Average

An average credit rating is considered to be a credit score of 650-699. This rating indicates that lenders may be concerned about the odds of a person or entity defaulting on their debt, but they still may not have a risk-free chance of getting the money back.

Poor

Credit ratings of 600-649 are considered to be poor and indicate a high risk of a person or entity not repaying their debt. Those with this rating are typically more risky for lenders and may be required to pay higher interest rates.

Bad

Those with a bad credit rating typically have a score of 600 or lower. This rating indicates that a person or entity is very likely to default on their debt and lenders may choose to not offer them any type of loan.

Importance of a Credit Rating

Having a good credit rating is incredibly important today. Having a rating that is deemed bad by lenders and creditors could affect almost every aspect of your life. A good credit rating can be extremely beneficial when it comes to obtaining credit, borrowing money, receiving competitive interest rates and more.

Access to Credit

Banks and lending organizations typically go through a borrower's credit report and score before approving or denying a loan or credit card application. A higher credit score can open the doors to various lending opportunities, while a low score can put you at risk of being rejected. If you don't have enough credit, there's even a chance that you may not be approved for loans or credit cards at all.

Interest Rates

A higher credit score means more access to competitive interest rates on loans and credit cards. The same can be said for mortgages, auto loans, and other types of financing. Conversely, a low credit score could mean you have to pay higher interest rates or may not be eligible for certain types of financing.

Insurance Rates

Insurers often use credit-based scores to determine your premium. A higher score generally means lower insurance premiums and vice versa. This could result in hundreds or even thousands of dollars in savings.

Employment

The job market is highly competitive, and employers may be more likely to hire applicants with better credit ratings. They may view applicants with a lower rating as being potentially irresponsible or lacking the ability to manage their finances properly. In certain industries, such as financial services, employers may even review an applicant's credit report as part of their screening process.

Improving Credit Ratings

A credit rating reflects an individual’s payment history for creditors and is calculated by credit bureaus like Equifax and TransUnion. A good credit rating can be beneficial for loan applications, rental applications, and more. To effectively improve a credit rating, individuals should:

Pay Bills on Time

Paying bills on time is essential to showing a good track record of timely payments. Credit bureaus take this into account when calculating credit ratings. Establishing a payment schedule is a great way to ensure payments are made in-time.

Reduce Credit Card Debt

The more available credit someone has, the better their credit score. Credit utilization ratio, or the amount of available credit used, is calculated when determining credit scores. Paying down credit card debt is a great way to show financial responsibility.

Negotiate Payment Plans

Clients who have made late payments or not paid amounts owed are encouraged to contact their lenders. Negotiating a payment plan may provide individuals with more manageable payment plans and save them money in the long term. Additionally, lenders may be willing to forgive past-due payments.

Track and Monitor Credit Reports

It is important to review credit reports and statements regularly to ensure accuracy and up-to-date information. Keeping track of credit reports also allows individuals to catch any errors as soon as possible and dispute them as needed. Individuals can also monitor their score to identify trends and areas to improve upon.

Conclusion

In conclusion, a credit rating is a numeric score that lenders use to evaluate the creditworthiness of potential borrowers. This credit score is used by banks, credit card companies and other financial institutions to assess whether someone is a suitable candidate for a loan and to set terms. It’s important to understand your credit score and tips for improving it, like paying bills on time, eliminating unnecessary debt, and limiting the number of credit applications.

Summary of Tips for Improving Credit Ratings

• Pay bills on time.
• Eliminate unnecessary debt.
• Get a mix of credit types (credit cards, installment loans, etc).
• Limit the number of credit applications.
• Monitor credit score regularly.
• Always pay the full balance on time.