Underneath it all, credit is a loan, and a loan is a debt. More specifically, credit is a contractual promise between a lender and a borrower for the latter to pay back the former, often with interest applied. When assessing a loan application, it makes sense that the lender should be assured that the potential borrower will be able to repay the loan in its entirety without any issues.
But how can a lender tell whether or not they are likely to see their loan paid back in full, with interest? That’s where a credit rating (or credit score) comes in.
If you’ve ever even tried applying for a credit card, you will probably know the term “credit rating”, and you might even have measured your own rating online. But while it is straightforward to check your credit rating on a site like Experian by filling in a few boxes, without context, that number means very little.
What is a credit rating?
A credit rating assesses how worthy of credit a borrower is, based on their past financial habits. Any entity that seeks to borrow money (be it a person, business or even a government) will have a credit rating assigned to it.
Individuals will have their credit rating assigned by a credit bureau such as the aforementioned Experian. Businesses and governments will have theirs assigned by a credit rating agency like S&P Global. That rating is then used by lenders to judge whether or not that entity is entitled to credit and on what terms. So, the better your credit score, the more likely you are to be offered credit at a lower interest rate.
What’s the difference between a credit rating and a credit score?
Generally speaking, a credit rating applies to a collective entity (like a business), whereas a credit score applies to an individual. The credit score is drawn from the individual’s credit history and takes the form of a three-digit number, usually between 300 (very bad) and 999 (excellent).
Short-term and long-term credit ratings
Every credit rating or score is given in relation to a period of time in which the lender will default on the loan. If that period is under a year, then it’s considered a short-term credit rating, whereas long-term credit ratings predict the borrower’s likelihood of defaulting on the loan at any given time after one year. In recent years, short-term credit ratings have become significantly more widespread.
What factors affect credit scores and credit ratings?
Several factors are considered when a credit rating is being assigned to both an individual and an organisation.
The first thing a credit agency will examine when performing a credit rating check is the applicant’s history of paying off loans and debts. If they have missed any payments or defaulted on a loan within that history then their rating is negatively affected and they could end up with bad credit. The agency will also look at the company’s financial future, and a positive potential outlook will result in a higher rating.
For an individual several factors are considered, some of which have a greater impact on the overall score than others. The most important factor is the individual’s payment history, followed by the overall amounts they currently owe. The length of a borrower’s credit history and the types of credit within that history will also play a part.
We can help
Ultimately, a good credit score or credit rating can be achieved by paying your debts on time and keeping on top of your finances, which is easier said than done.
If you’re interested in learning more about credit ratings and how to improve your credit score then get in touch with our financial experts. Visit our website to find out how GoCardless can help you with ad hoc payments or recurring payments.