Credit rating agencies are companies that provide objective estimates on how capable a debt issuer (ex. banks, companies, governments) is in fulfilling its debt obligations. Today we usually see these valuations expressed in letters like AAA, BB+, or D.

Understanding Credit Ratings

A loan is a debt—essentially a promise, often contractual. A credit rating determines the likelihood that the borrower will be willing and able to pay back a loan within the confines of the agreement without defaulting.

An individual's credit rating affects their chances of approval for a given loan and favorable terms for that loan. A high credit rating indicates a strong possibility of paying back the loan in its entirety without any issues. In contrast, a poor credit rating suggests that the borrower has had trouble paying back loans and might follow the same pattern in the future.

Credit ratings and credit scores

Credit ratings apply to businesses and governments as well as individuals. For example, sovereign credit ratings apply to national governments while corporate credit ratings apply solely to corporations. Credit scores, on the other hand, apply only to individuals.

Credit scores are derived from the credit history maintained by credit-reporting agencies such as Equifax, Experian, and TransUnion. An individual's credit score is reported as generally ranging from 300 to 850 (see more under Factors Affecting Credit Ratings and Credit Scores).

A short-term credit rating reflects the likelihood that a borrower will default within the year. This type of credit rating has become the norm in recent years, where long-term credit ratings were more heavily consider in the pastured. Long-term credit ratings predict the borrower's likelihood of defaulting at any given time in the extended future.

Credit rating agencies typically assign letter grades to indicate ratings. S&P Global, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB is considered to be a speculative-grade or junk bond, which means it is more likely to default on loans.