For individuals and companies, credit quality measures a borrower’s ability to repay their debt and is an important factor in determining their credit risk. Most lenders will use credit scores to evaluate the credit quality of an individual borrower or business.
In other contexts, investors use credit quality through bond ratings when analyzing bonds or bond funds. Learn more about the different roles of credit quality and how it is determined in each situation.
Definition and Examples of Credit Quality
Credit quality measures a borrower’s ability to repay their debt, giving lenders a sense of the risk of lending to them. Typically, lenders will usually look at a borrower’s credit score to help determine their creditworthiness before issuing loans, credit cards, or other financial products.
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.
Credit scores are determined by a borrower’s payment history, total loan balances, and other factors. Borrowers with a history of making late payments or defaulting on their debt will have a lower credit score, indicating lower credit quality.
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.
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.
Your credit score will fall somewhere within a range of 300 to 850, and the higher it is, the better. If you have a higher credit score, lenders see you as less of a financial risk and will be more likely to offer you the best rates and terms on your loan.
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.
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.
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.
- Credit quality measures a borrower’s ability to repay their debt.
- Credit quality is also used to evaluate the quality of a bond or mutual fund.
- Most lenders use a borrower’s FICO score to determine their credit quality.
- Business credit reporting agencies like Dun & Bradstreet, Experian Commercial, and Equifax Small Business evaluate the credit quality of businesses.
- Credit rating agencies like Moody’s, Standard & Poor’s, and Fitch help investors compare the strength of bonds.