Credit scoring vs. credit rating: understanding the differences and their implications

While often used interchangeably, credit scoring and credit rating are distinct concepts with different applications and implications.
Credit Rating
Credit ratings are primarily used to evaluate the creditworthiness of companies, sovereign entities, sub-sovereigns, and their associated securities, including asset-backed securities. These ratings are graded on a lettered scale (e.g., AAA, AA, A, BBB) and are essential for determining both the interest rates for repayment and the approval for loans or debt issuance. Credit ratings provide investors and stakeholders with a detailed assessment of the financial stability and risk associated with large entities.
Credit Scoring
In contrast, credit scoring models create a picture of an individual’s relationship with credit. These scores, which can vary slightly among the three major credit bureaus (Experian, Equifax, and TransUnion), rank a borrower’s riskiness from highest to lowest. A higher credit score indicates lower credit risk and can lead to better terms on financial products like credit cards, mortgages, and auto loans.
Limitations of Credit Scoring
Credit scoring has its limitations. One major drawback is that it does not provide an explicit estimate of a borrower’s default probability. Instead, it ranks individuals based on their credit risk without quantifying how much riskier one borrower is compared to another. Additionally, traditional credit scoring models do not account for current economic conditions. For instance, a borrower with a high credit score may not see their score adjust during an economic downturn unless there is a change in their financial behavior or position.
To address this issue, FICO introduced the FICO Resilience Index. This tool evaluates consumers’ resilience to economic downturns, offering lenders additional insight into which consumers are more likely to default during periods of economic stress. This index can be used alongside traditional credit scores to enhance credit decisions and strategies.
Advances in Credit Risk Modeling
Technological advancements, such as machine learning and advanced analytics, are refining the accuracy of credit risk modeling. More sophisticated methods, including structural and reduced-form models, are now used to better assess default probability, providing a more nuanced understanding of credit risk.
Improving Your Credit Score
Improving your credit score involves several proactive steps:
- Timely Payments: Ensure all your payments are made on time.
- Debt Reduction: Decrease your overall debt levels.
- Credit Mix: Maintain a healthy mix of credit types, including revolving credit (credit cards) and non-revolving loans (auto loans, mortgages).
- Credit History: Keep your accounts open to build a longer credit history.
Impact of Bankruptcy on Credit Scores
Bankruptcy can significantly lower your credit score and remains on your credit report for 7 to 10 years. If you are struggling with debt, consider alternatives such as debt consolidation before opting for bankruptcy.
Exceptional Credit Scores
An exceptional credit score ranges from 800 to 850. While the average FICO score is 714, about 21% of people have a score of 800 or higher. Notably, less than 1% of borrowers with exceptional scores become seriously delinquent on their payments.