What is a credit rating?

Credit rating and credit score are two terms that are often used interchangeably by consumers, but keep in mind that they're not the same. A credit rating measures the ability of a business or government to repay its financial obligations by looking at its history of borrowing and repaying loans. A credit score does the same, but measures individuals (and in some cases, small businesses).

The difference between a credit rating and a credit score

A credit rating is expressed as a letter grade and conveys the creditworthiness of a business or government. It's used to establish whether a loan should be granted to a business, and if the loan moves forward, it helps determine the length and term of the loan.

The assessment and evaluation for companies and governments are typically performed by a credit rating agency, such as Moody's Investor Services, Standard and Poor's (S&P) and Fitch Group. These ratings are used by investors, issuers of debt, investment banks, businesses and corporations. A typical credit rating scale uses letter ratings, but a numerical score is used to convey the creditworthiness of an individual consumer or small business.

Credit scores are assigned to each person over the age of 18 and some  small businesses. The scores typically consist of three-digit numbers. They're used by lenders to determine your creditworthiness. It considers several factors including how consistent you are with making credit card payments, loans and other bills. Individual credit scores for consumers are generated by each of the three major credit reporting agencies (Experian™, Equifax^® and TransUnion^®) and the scores usually range from 300 to 850.

A credit score indicates an individual's credit health. This indicates whether the individual can undertake a certain loan, as well as their ability to repay it. It's used by banks, credit card companies and other lending institutions that serve individuals.

What is a good credit rating?

All agencies set different scales, but the most popularly used scale is the one produced by S&P Global. This scale uses AAA ratings for corporations or governments that have the highest likelihood to meet their financial commitments. This is followed by AA, A, BBB, BB, B, CCC, CC, C and D. Pluses and minuses may be added to the rating to differentiate between ratings from AA to CCC.

A triple-A rating is considered the best. It shows that the borrower is extremely capable of meeting its financial commitments. Ratings of BB or lower are considered “junk" ratings. Agencies with scores that fall between the two categories are average but may be under observation by the credit rating agencies. Ratings lower than BBB are considered “non-investment grade," while those between BBB and AAA are considered “investment grade."

A credit rating of D may be given when financial obligations aren't met and payments aren't made. This low rating is also used when filing for bankruptcy or if the company has defaulted on their debt. Maintaining a good credit rating can improve your likelihood of banks and lenders approving you for financing. A poor credit rating may show that you're unable to repay debt and limit your financing options.

Why credit rating is important

A credit rating is a major factor when deciding whether a borrower receives the loan they're applying for. If your credit rating is in good standing, the chance of easily borrowing from financial institutions may increase. It helps determine the probability that you'll pay back the money that was borrowed, as well as the risk you pose to a lender.

Banks typically base the terms of a loan off your credit rating or credit score, therefore, the better your credit rating, the better the terms of your loan. If you have a poor credit rating, this may stand in the way of you obtaining a credit card or mortgage. Businesses and governments may also benefit from high credit ratings.

Many lenders will keep the 5 C's of credit in mind when looking at your overall credit. The 5 C's of credit are:

1. Character
2. Capacity/Cashflow
3. Capital
4. Conditions
5. Collateral

These characteristics are used by the lender to evaluate your potential as a borrower and assess your creditworthiness. Lenders also look at credit reports, credit ratings, credit scores and other documents that are relevant to the financial situation, as well as information about the loan. 

How can you establish a credit rating?

Establishing and maintaining a good credit rating is an important way to increase your chances of borrowing money. A low credit rating could prevent you from borrowing any money at all. Here are several ways you can establish credit:

Check your credit report

Checking your rating or score will help you better understand the state of your credit. By looking at your credit report, you may be able to get the information you need to raise your rating or score, including which accounts are affecting it negatively and any disputable items on the report.

Pay your bills on time

Paying your bills on time may seem like an easy decision, but it's one of the easiest ways to establish a credit rating. If you don't make on-time payments, there's a good chance that your credit rating and score will suffer. Lenders may view you as a potential debt risk.

Establish any errors and inquiries

The information in your report should be accurate and up to date. If there are any errors on your profile, it's possible to remove them from your report after filing a dispute.

Decrease your credit utilization ratio

Credit rating and reporting agencies look at the ratio of credit used compared to the amount that is available to you, so it may be wise to keep your credit utilization ratio low. You may be able to do so by paying off your balances, increasing your credit limit, decreasing spending, and opening a new line of credit.

Understanding your credit rating and how lenders use it to make decisions is a helpful way to improve your financial literacy. In addition, you can use this information to improve and monitor your credit score over time.