A credit rating is an assessment or evaluation of borrowers’ (individual, corporation, government, etc.) ability to fulfill their financial obligation (paying debt without default). The first available credit rating was issued by Moody in 1909, and it became popular in 1936 when a new rule was issued to prohibit banks from investing in low credit ratings bonds.
Credit rating is highly effective because it helps lenders decide whether to approve it or not. A high credit rating suggests that borrower is very likely to pay back the loan in time while a low credit rating indicates that borrowers may have trouble paying the debt, not only this time, but also in the future.
In the case of personal finance, individual credit rating and credit score are quite similar. Individual credit rating is generally scored with Fair Isaac (FICO) credit scoring system by credit bureaus. It is a numeric scale system and calculates individual credit score based on their payment history, amounts owed, credit history, types of credit and so on, ranging from 300 to 850.
However, in the case of corporate finance, credit rating is generally issued by credit agencies, such as Standard & Poor’s (S&P), Moody’s, or Fitch for their client companies, ranging from AAA to D. Under this circumstance, if a bond’s credit rating is BB or below, it is considered as a speculative bond or a junk bond, which means that it is very risky to invest in it.
How important it is?
Most borrowers strive for a high credit rating because it has a huge impact on the following aspects.
- Credit rating will influence lenders’ decision of loan approval. If the borrower has a poor credit rating, it is very likely for the lender to reject the loan request.
- Credit rating will influence the interest rate of the loan. In most cases, the higher the risk level is, the higher the interest rate is. For those start-up companies, a high interest rate can be a disaster for them.
- Credit rating will influence investor’s decision of purchasing the bonds. A poor credit rating is very risky since it suggests that the company may have difficulty in bond payments.
- Credit rating will leave a lasting effect. Credit rating changes all the time thus one negative default or breach will bring down the total rating level, which can take a long time to build up.
- Credit rating will influence financial markets. A downgrade of credit rating will bring down the whole market’s performance.