For example, if you are applying for a credit card with an “exceptional” credit score of above 800, you will likely qualify for the lowest interest rates. However, if your credit score is “poor,” or below 579, your rates will most likely be much higher, assuming you’re approved for the credit card at all. One of the best ways to improve your credit score is by making your payments for loans and credit cards on time. Your payment history accounts for 35% of your FICO score, so if you struggle to make timely payments, your score will take a hit. In other contexts, credit quality refers to the measures that investors use to evaluate a bond’s risk. Credit rating agencies assign specific ratings to bonds based on their credit quality. For example, credit rating agency Moody’s may give a bond with good credit quality a rating of AAA—the highest it offers. An investor whose main goal is to preserve their capital may favor that bond over another bond with a lower rating. A lower-rated bond indicates that, while the bond may have more return, it also has greater risk.
How Does Credit Quality Work?
Lenders and investors use different strategies to evaluate the credit quality of an individual, business, or bond. Let’s look at how credit quality is determined in each case.
Individuals
Most lenders use a borrower’s credit score to determine their credit quality before issuing products like credit cards, personal loans, mortgages, and auto loans. Your credit score—a three-digit number that evaluates how likely you are to repay your loan—is calculated using the information in your credit report. There are different credit scoring models, but most lenders will look at your FICO score. If your credit score is lower, it will be harder for you to obtain credit because lenders will see you as a higher risk. And if you do qualify, you’ll pay higher interest rates on your loan. Regularly review your credit report to ensure the information is correct and to monitor for signs of identity theft. You’re legally entitled to receive a free copy of your credit report from each credit reporting agency (Experian, Equifax, and TransUnion) every 12 months. To request a copy of your report, visit AnnualCreditReport.com.
Businesses
A business credit report is an important tool that lenders use to evaluate the credit quality of a company. The information in this report shows whether the business has a history of paying its bills on time and whether the company has ever defaulted on a loan. Business credit reporting agencies like Dun & Bradstreet, Experian Commercial, and Equifax Small Business use this information to calculate a business’s credit score. A business credit score measures the company’s financial stability and can determine the types of rates they will receive on a loan.
Bonds
Investors use credit quality to evaluate the investment quality of a bond or bond fund by looking at its rating. The bond’s credit rating, also called its bond rating, informs investors about the creditworthiness of a specific bond or the securities in a bond fund. Credit rating agencies like Moody’s, Standard & Poor’s, and Fitch calculate bond ratings. These agencies evaluate the creditworthiness of the bond based on the issuer’s ability to make payments and repay the loan. Bonds with a lower rating usually offer higher yields to compensate for the risk. Each credit rating agency has its own scoring process, but their ratings are similar. This helps investors compare the strength of the investment to other bonds. For instance, a AAA rating is considered the strongest investment grade at each agency, while a BB+ (Ba1 at Moody’s) or below is considered a non-investment grade. At all three agencies, C or D ratings are the weakest grades a bond can receive.
