Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Credit Quality

What it is:

Credit quality is a measure of an individual's or company's creditworthiness, which is ability to repay debt.

How it works (Example):

A FICO score, which is created and calculated by the Fair Isaac Corporation, is a measure of an individual's credit quality. It is a mathematical summary of the information on a person's credit report. Bond ratings are measures of the credit quality of companies that issue bonds. These ratings can also be assigned to insurance companies or other entities or securities to indicate riskiness.

FICO scores range from 300 to 850. The higher a person's score, the more creditworthy that person is. The best interest rates tend to go to borrowers with FICO scores above 740, but this is a generalization. The FICO-score algorithm considers several things in determining credit quality: payment history, the amount owed, the length of the person's credit history, the amount of borrowing capacity and the types of debt the borrower uses. The three major credit bureaus (Experian, TransUnion and Equifax) each collect information about a person's credit quality, so it is possible for a person to have three different measures of credit quality (i.e., three different FICO scores).

Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading the credit quality of bond issuers based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

  • For S&P the ratings vary from AAA (the most secure) to D (for default).
  • For Moody's the ratings go from Aaa to C, which means the issuer is likely already in default.

Only bonds with a rating of BBB or better are considered "investment grade." BBB bonds are considered to be suitable for investment by institutions. Anything below the triple-B rating is considered to be junk, or below investment grade. Bond ratings are revised periodically based on recent data. Treasury bonds are are backed by the "full faith and credit" of the United States government and are thus considered investments of the highest credit quality because the government has the power to levy taxes in order to pay its debts.

Why it Matters:

Credit quality tremendously affects the amount of credit for which a person or business qualifies and the interest rate he or she pays for that credit. A person with a low FICO score, for example, might have to pay 10% on a loan for which a person with a higher FICO score would have to pay only 6%. Thus, when it comes to mortgages, car loans and other large borrowings, a good FICO score can save a person thousands of dollars.

Credit quality also has a huge influence on the price and demand for certain bonds. The lower the credit quality, the riskier the investment and the less the investment is worth. This is why downgrades (or rumors of downgrades) in an issuer's credit rating can have a significant impact on its bonds and on the market or industry.

Ultimately, however, improving a person's or a company's credit quality generally centers on a few concepts: paying bills on time, getting current and staying current on bills, keeping debt balances low, avoiding unnecessary credit, avoiding opening a lot of new credit accounts at a young age, checking one's credit report for mistakes and judiciously using credit accounts.

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