Credit Ratings And Why They Matter

A credit rating and credit score may sound like they're the same thing, but they're not. Credit rating is used to refer to businesses and government when it comes to their debts. Even if it doesn’t seem like it directly affects consumers, it can, especially when it comes to investing. 

What Is A Credit Rating?

A credit rating is a letter grade that tells lenders the likelihood that a business or government will pay their debts. These ratings can vary widely based on the agency issuing the rating, the country the company (sometimes called the debtor) is in, and the type of rating being used.

Understanding Credit Ratings

Credit ratings are used to estimate how risky it could be when it comes to investing or lending money to an entity, like a business or the government. There are different credit rating agencies that use various factors to determine a business or government’s risk. The higher the credit rating, the more likely the entity is to repay its debts to its investors. On the other hand, a lower credit rating could mean that the entity would fail or struggle to repay what is owed.

There are short- and long-term credit ratings. Short-term ratings look at how likely it is that an entity will default on their debt within a year, and long-term looks toward the likelihood of default in a longer time horizon.

Both lenders and investors use credit ratings to determine whether they're willing to work with a certain business or entity based on the risk that may be involved. They may also look at credit ratings to determine how much interest they may receive — entities with higher ratings may pay less interest, but there is a lower amount of risk for default.

The History Of Credit Ratings

Credit ratings were created in the early 20th century and were more popular when federal banking regulators created new legislation around 1936 to prevent banks from investing in bonds with low credit ratings. The idea was to help banks avoid defaulting because of financial losses. Eventually, other financial institutions and companies also started using credit ratings to assess risk and prevent losses.

Major credit rating agencies include:

• Fitch Ratings
• Moody's Investors Service
• S&P Global
  

The U.S. Securities and Exchange Commission, or SEC, helps to oversee these credit rating agencies.

Importance Of Credit Ratings

Credit ratings are crucial for investors as well as the entities that are being rated. That's because higher ratings could mean that the entities being rated may have a higher chance of accessing loans or funds from investors. With lower credit ratings, companies may have to pay higher rates to access loans.

How Credit Ratings Work

Companies or entities will pay a credit rating agency to rate their organization or the securities they issue. The credit rating agency will use various factors to establish a rating, which is then released to the public. Credit rating scales typically uses letter ratings and are then used by investment banks, businesses and other types of investors and debt issuers. These credit rating agencies work hard to ensure there are no potential conflicts of interests when determining a credit rating for an entity.

Credit Rating Scale

In most cases, credit rating agencies use letter grades. A rating of C or D is the lowest, and a rating of AAA is the highest.

The following table illustrates how the three major credit rating agencies use letter grades (from best to worst, top to bottom in each column):

Credit Ratings Vs. Credit Scores

The main difference between a credit rating and a credit score is that they look at different risk profiles. Credit ratings look at the chances a business or government will default on a loan, and credit scores look at the likelihood an individual will default on one. Whereas investors, companies, or debt issuers can use credit ratings, lenders are the ones using credit scores.

Unlike credit ratings, credit scores typically range from 300 to 850 — the higher the number, the higher your score. Higher credit scores also signal to lenders that you are a lower risk borrower.

Credit Ratings: FAQs

Want to learn more about credit ratings? Here are some frequently asked questions about them.

What does a credit rating tell an investor?

A credit rating shows an investor the likelihood a company or other type of entity will default on their debt obligations. It can also tell whether the entity will pay out higher or lower interest to investors.

What is a nationally recognized statistical rating organization?

This term refers to a credit rating agency that's been approved by the U.S. Securities and Exchange Commission (SEC). These credit rating agencies need to adhere to SEC regulations, such as how it provides ratings for entities.

The Bottom Line

Credit ratings are important for businesses and governments that want to receive funding from lenders and investors. While it does show potential risks, they're not a guarantee that lenders and investors will receive a return for any funds they offer.

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