Credit Ratings Explained
A credit rating (also known as a credit score) is an assessment of how “worthy” somebody is of credit. It’s based upon: history of borrowing and repayment, assets, liabilities and income. These ratings are used by lenders (banks, credit card agencies and car financiers among others) to estimate the probability that the borrower (individuals, corporations and even governments) will repay their debt. It’s also important to realize early on that lenders are not only interested in high rates of repayment, they are also looking for high profit levels, which is why they are willing to take on riskier individuals as long as they can charge them a higher rate of interest.
In simple terms if you have a poor credit rating then you’re more likely to default (not pay) your loan than somebody with a high credit rating, you’re also more likely to become “bad debt” (somebody who doesn’t make their repayments on time). Because of this risk somebody with a poor credit rating is less likely to be approved for a loan or credit card than somebody with a high credit rating. Those who are accepted for a loan are likely to receive a higher interest rate than somebody with a high credit rating.
These credit ratings are calculated by having complicated mathematical algorithms applied to data which is collected by companies known as credit bureaus. The most commonly used algorithm is something called FICO, this was developed by Bill Fair & Earl Isaac in 1956. It uses the following information to come up with a three digit score between 300 and 850; payment history, credit utilization ratio, length of credit history, recent searches for credit & other factors.
Whenever you apply for a loan, whether it be for a mortgage, car loan or even a credit card the lender will look at your FICO score. This score is used to determine whether you should be approved or denied, but it’s also used by companies to determine the rate of interest that you should be offered. Before you apply for a loan, you should check your score. A score of above 760 will mean that you will be offered the best rate of interest whilst anything below that might cause you to be denied or offered a higher rate of interest. Most companies charge money to get access to this score, but we’ve outlined how you can get a Free FICO Score.
Individual Credit Ratings:
Individuals credit ratings and credit histories are maintained, compiled and calculated by credit agencies (see also: credit bureaus). These reports contain information such as; late payments, loan defaults, credit history. In some countries demographic data such as your age, sex and residence are also used in calculating your credit ratings – while in others using demographic data is strictly off limits and is protected by specific anti discrimination laws.
United States Of America Credit Ratings:
In America there are three main agencies, they are;
Each of these companies also provide credit scores which analyse the data found in the credit reports/records that they keep, the most common score used in America is a three digit number called a FICO score which was set up by the FICO company in the late 50′s. Each of the three credit bureau’s have their own branded FICO scores based on their data.
In 2001 FICO launched another scoring system titled NextGen Score, which they claimed could increase the amount of loans that lenders could give while also decreasing the amount of defaults and “bad” loans. It was not widely adopted and has since been scraped in favor of NextGen 2 Score which is similar to their previous offering although much harsher on the subprime market after the collapse in the late 2000′s. NextGen 2 is also struggling to be adopted by lenders.
In 2006 the three major credit bureaus launched Vantage Score to try to compete with FICO score, this is also a three digit number which ranges from 501-990. According to documents that were made public in the FICO v. VantageScore lawsuit Vantage score controls less than 6% of the market.
Every American is entitled to one free credit report every twelve months. To receive you’re free report – follow our guide here.
Canadian Credit Ratings
Canada has two of the same credit bureau’s as the USA, they are:
The most commonly used rating in Canada are North American Standard Account Ratings (also known as the R Ratings), these range from R0-R9.
Unlike USA, every Canadian is allowed an unlimited amount of free credit reports (via mail only, internet access reports which can include a person’s credit score are not free).
UK Credit Ratings
In the United Kingdom credit scores are most commonly referred to as credit scorecards. Basic scorecards aim to answer questions with a binary outcome (two options only, 1 or 0). An example of a basic score card would be as follows;
|What this result means||Bad Debt||No Bad Debt|
In this scenario the scorecard is aiming to determine whether a new customer is likely to become bad debt (default or not pay their loan) or if the customer will have no bad debt. If the binary score comes back with a 1 then the mathematical model that the scorecard uses has determined that this borrower is likely to become bad debt – thus causing them to be denied for their loan.
More advanced scorecards are being developed that aim to give a range of results (for example, how much bad debt is this new debtor likely to incur) rather than a binary result.
The UK is heavily regulated by the Financial Services Authority (FSA) which follows the Basel II regulations.
Australian/New Zealand Credit Ratings
There are two main credit bureaus in Australiasia, they are:
- Veda Advantage
- Dun & Bradstreet
These agencies are required to give individuals a free credit report, although there has been some criticism that they make obtaining your free report more difficult than it needs to be and often try to up sell people into purchasing their “paid express” versions.
For those living in Tasmania, you can receive a credit report from the Tasmanian Collection Service – although no free reports are available (reports start from $5.50 including GST).
In Australiasia credit ratings are made by lenders themselves at the time of credit application and are not shared with the individual . These ratings are used to approve or deny applications, they are also used in the setting of credit limits on credit cards and mortgages.
Austrian Credit Ratings
Rather than using credit ratings, Austria instead uses a blacklist system. If you default on any line of credit (an unpaid electricity bill for example) then you will be added to a credit bureau blacklist.
Banks do not use these blacklists, instead they measure consumers credit worthiness by looking at their income and assets. Consumers must also opt in for any of their private data to be collected, at any stage they can opt out at any time and then any further collection or distribution of this data is made illegal. This is protected by the Data Protection Directive.
Austrian consumers may also view all their data collected by the credit bureau’s for free once per year.
Indian Credit Ratings
In 2000 the first credit bureau in India was created, called CIBIL (Credit Information Bureau India Limited) to address the growing need for accurate credit data on India’s growing credit consumers. CIBIL contains 175 members which consist of all the major banks, financial institutions, housing finance companies, state financial corporations and credit card companies. Membership is based on reciprocal data (you must share financial data with the other members to join).
The data that CIBIL collects is used to create credit information reports (CIR) which are used by Indian lenders to either approve or deny credit applications.
Transunion India also use this data to come up with the calculate CIBIL TransUnion Score, which ranges from 300 (poor credit rating) to 900 (excellent credit rating)
Individuals may also access this data, unfortunately it doesn’t fall under the Right To Information Act, 2005 and such CIBIL is able to charge Rs142 rupees for a CIR and Rs440 for a CIR + CIBIL TransUnion Score.
There are three main credit bureau’s in norway, they are;
- Dun & Bradstreet
- Lindorff Decision
These companies base their scoring off publicly available data which includes; tax returns, taxable income and most importantly Betalingsanmerkning (a record of non payment). Interestingly it also uses demographic data in it’s analysis such as an individuals age or sex which is off limits in most other countries. One example that is often cited is that it’s not unusual for a young person to check their credit rating multiple times in a year as their data is relatively new and thus more prone to bigger movements – while somebody who is older has little reason to constantly check their credit rating.
When an individual is scored they are required to be notified either by regular post or via e-mail of their score, along with any information used to come to this score and the name of the institution that calculated this score.
Corporate Credit Ratings
Corporate credit ratings are a measurement of the likelihood that a corporation will be able repay it’s debt. It’s therefore seen as a measurement of their debt securities (such as bonds) rather than a measurement of the companies overall health.
There are three main credit rating agencies that deal with corporations that dominate the market with 90-95% of the market share, they are;
These agencies typically use letter assigned ratings with AAA (highest quality and most likely to pay it’s debt back) on one end and C/D (this is Junk credit quality often meaning the corporation has already missed payments to other lenders) on the other end. A full list of what each of the letters means can be found below.
|Moody’s||Standard & Poor’s (S&P)||Fitch||Credit Worthiness/What This Means|
|Aaa||AAA||AAA||This corporation has an extremely strong capacity to meet it’s debt & financial commitments. There are currently four companies which are AAA according to S&P, they are; Automatic Data Processing (NYSE:ADP), Johnson & Johnson (NYSE:JNJ), Microsoft (NASDAQ:MSFT) and ExxonMobil (NYSE:XOM). Source.|
|Aa1||AA+||AA+||This corporation has a very strong capacity to meet it’s debt and financial commitments. The difference between this an a triple A rating are small.|
|A1||A+||A+||This corporation has a strong capacity to meet it’s debt and financial commitments but it more susceptible to big changes in economic conditions and other adverse situations.|
|Baa1||BBB+||BBB+||This corporation has an adequate capacity to meet it’s debt and financial commitments but changing conditions and circumstances are likely to lead to a weaken capacity to meet these commitments.|
|Ba1||BB+||BB+||This corporation faces major ongoing uncertainties and exposure to adverse economic financial or business conditions could lead to an inability to meet it’s debt and financial commitments. . None the less this corporation is less vulnerable at least in the near term than other lower rated corporations.|
|B1||B+||B+||This corporation currently has the capacity to meet it’s debt and financial commitments but adverse economic, financial or business conditions could lead to an inability to meet these commitments. It is more vulnerable than corporations rated BB or above.|
|Caa||CCC||CCC||This corporation is dependent on favourable economic, financial and business conditions to be able to meet it’s debt and financial commitments, it’s currently vulnerable.|
|Ca||CC||C||This corporation is currently highly vulnerable and if significant favourable economic financial business conditions do not occur it will be unable to meet it’s debt and financial commitments.|
|C||C||This corporation is highly likely to provide non-payment for it’s debt and financial obligations. This is often used when a bankruptcy petition has been filed.|
|C||D||D||This corporation has failed to pay one or more of it’s debt or financial obligations when it was due.|
|e, p||pr||Expected||Preliminary ratings may be assigned to obligations pending receipt of final documentation and legal opinions. The final rating may differ from the preliminary rating.|
|WR||Rating withdrawn for reasons including: debt maturity, calls, puts, conversions, etc., or business reasons (e.g. change in the size of a debt issue), or the issuer defaults.|
|unsolicited||unsolicited||This rating was initiated by the ratings agency and not requested by the issuer.|
|SD||RD||This rating is assigned when the agency believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner.|
|NR||NR||NR||No rating has been requested, or there is insufficient information on which to base a rating.|
The ratings AA to CCC may be modified with plus or minus signs to indicate relative standings within categories. Often termed credit watches these intermediate ratings indicate whether it is likely that a credit rating is to be upgraded or downgraded depending on the intermediate performance of the corporation.
Sovereign Credit Ratings/National Government Credit Ratings
A sovereign credit rating aims to measure the level of risk when investing in a sovereign entity (e.g national government) it takes into account; political risk, economic performance/projections, structural assessment, debt indicators, access to banks, access to capital markets and other credit ratings. It’s broken down into three main scoring categories; Economic Risk, Political Risk & Financial System Risk. Below is a list of the least risky sovereign entities. The results focus primarily on sovereign default risk/default payment risk (also known as trade credit risk).
We hope you’ve enjoyed learning more about credit ratings, if you have any further questions you can ask in the question and answer section.