How credit ratings work

Last Updated at: November 04, 2019
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How credit ratings work

Last week, the Investment Credit Rating Agency popularly known as ICRA, reduced the credit ranking of one of the greatest players in the Indian aviation industry, Jet Airways. This was primarily because Jet had defaulted in loan repayments which led to the credit agency reducing the rating from ‘C’ to ‘D’. The credit ratings assume importance, not just for large industrial houses but also firms, proprietorships and individuals.

In this post, we examine what these ratings mean and examine factors that may lead to upgrading and downgrading of these ratings, while also highlighting facets of maintaining a high rating.

How is a credit rating assigned?
Most credit ranking companies collect and maintain record of individuals and commercial entities’ payments with reference to the loans taken by them or their credit card repayment status. These records are submitted by banks, financial institutions and lenders on a routine basis, using which a report is made that contains a grade known as the credit rating. It is on the basis of this report that lenders approve pending loan or renew credit card applications.

Although each credit rating agency follows a slightly different grading, an A grade suggests substantial security to the lender whereas a D grade indicates high risk of default. Some agencies also give a score, where a higher score often indicates a greater ability to service debt.

In case of a low score, a lender may reject the application outright. Similarly, for a very high credit score that indicates timely payments and creditworthiness, banks, financial agencies or government may offer subsidised rates of interest or grant other concessions. This is one scenario, where the first impression of a high or a low score can make a huge difference.

Manifestations of the credit rating
While ICRA focuses on Indian companies, MSME and large industrial houses (and not international companies or organizations), there exist other major five other credit ratings agencies registered with SEBI that have specialized focus on insurance agencies, rural and agricultural industries, small businesses etc.

Other than merely assigning a credit rating, the advantages that some of these agencies offer include risk assessment, analytical solutions, investment information and advice on performance ratings.

Talk to Experts

What should you do to maintain a high credit rating?
Jet Airways in the recent past has been hit by increasing operational costs, fuel prices, depreciating rupee and weak demand on international sectors that contributed to huge losses and hence, failure to repay pending installments. The following pointers indicate what specific cautions can help improve your credit score:

  • Paying installments on time– Timely payments without waiting till the last date of payment is the easiest way to ensure that you do not lose your rating.
  • Keeping the maximum credit threshold low – Most credit card companies would want to offer a higher spending limit to its customers. However, it’s prudent to keep this limit low, so you’re not tempted to overspend by the end of your credit period.
  • Having both secured and unsecured loans: Secured loans are those obtained against a specific asset, such as a housing loan or a car loan. Unsecured loans do not have the security of an underlying asset, such as certain personal loans, credit card etc. A higher proportion of unsecured loans may also raise concerns about repayment to prospective lenders.
  • Exercising caution while obtaining new credit– Banks may not view piling of multiple loans from varied sources positively, as it consequently increases risk for all lenders involved. Before thinking of obtaining additional loan, one should explore alternatives to funding, instead of resorting to increased debt burden.
  • Monitoring joint accounts –Even if one has a personal agreement with joint owners of an account on which loan has been obtained, and the responsibility of repayment is assigned, in case of a default, all owners of the joint account are likely to suffer downgrading of rating. This makes it extremely important to monitor regular payments on joint accounts.
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How credit ratings work

535

Last week, the Investment Credit Rating Agency popularly known as ICRA, reduced the credit ranking of one of the greatest players in the Indian aviation industry, Jet Airways. This was primarily because Jet had defaulted in loan repayments which led to the credit agency reducing the rating from ‘C’ to ‘D’. The credit ratings assume importance, not just for large industrial houses but also firms, proprietorships and individuals.

In this post, we examine what these ratings mean and examine factors that may lead to upgrading and downgrading of these ratings, while also highlighting facets of maintaining a high rating.

How is a credit rating assigned?
Most credit ranking companies collect and maintain record of individuals and commercial entities’ payments with reference to the loans taken by them or their credit card repayment status. These records are submitted by banks, financial institutions and lenders on a routine basis, using which a report is made that contains a grade known as the credit rating. It is on the basis of this report that lenders approve pending loan or renew credit card applications.

Although each credit rating agency follows a slightly different grading, an A grade suggests substantial security to the lender whereas a D grade indicates high risk of default. Some agencies also give a score, where a higher score often indicates a greater ability to service debt.

In case of a low score, a lender may reject the application outright. Similarly, for a very high credit score that indicates timely payments and creditworthiness, banks, financial agencies or government may offer subsidised rates of interest or grant other concessions. This is one scenario, where the first impression of a high or a low score can make a huge difference.

Manifestations of the credit rating
While ICRA focuses on Indian companies, MSME and large industrial houses (and not international companies or organizations), there exist other major five other credit ratings agencies registered with SEBI that have specialized focus on insurance agencies, rural and agricultural industries, small businesses etc.

Other than merely assigning a credit rating, the advantages that some of these agencies offer include risk assessment, analytical solutions, investment information and advice on performance ratings.

Talk to Experts

What should you do to maintain a high credit rating?
Jet Airways in the recent past has been hit by increasing operational costs, fuel prices, depreciating rupee and weak demand on international sectors that contributed to huge losses and hence, failure to repay pending installments. The following pointers indicate what specific cautions can help improve your credit score:

  • Paying installments on time– Timely payments without waiting till the last date of payment is the easiest way to ensure that you do not lose your rating.
  • Keeping the maximum credit threshold low – Most credit card companies would want to offer a higher spending limit to its customers. However, it’s prudent to keep this limit low, so you’re not tempted to overspend by the end of your credit period.
  • Having both secured and unsecured loans: Secured loans are those obtained against a specific asset, such as a housing loan or a car loan. Unsecured loans do not have the security of an underlying asset, such as certain personal loans, credit card etc. A higher proportion of unsecured loans may also raise concerns about repayment to prospective lenders.
  • Exercising caution while obtaining new credit– Banks may not view piling of multiple loans from varied sources positively, as it consequently increases risk for all lenders involved. Before thinking of obtaining additional loan, one should explore alternatives to funding, instead of resorting to increased debt burden.
  • Monitoring joint accounts –Even if one has a personal agreement with joint owners of an account on which loan has been obtained, and the responsibility of repayment is assigned, in case of a default, all owners of the joint account are likely to suffer downgrading of rating. This makes it extremely important to monitor regular payments on joint accounts.
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Avani Mishra is a graduate in law from the National Law Institute University, Bhopal. She qualified the Company Secretary course with an All India Rank 1 and is a recipient of the President’s Gold Medal for her academic distinctions. She also holds a B.Com degree with a specialization in Corporate Affairs and Administration.