How Your Credit Score Affects Interest Rates

Relationship between Credit Scores and Interest Rates

The Relationship Between Credit And Interest.

People talk all the time about how you need a good credit score if you want a stable financial life. Heck, we talk about it around here nearly every week! But Why is that, exactly? Why does your ability to borrow money for, say, a new house or new car, depend so much on one number?credit score

Interest rates have a big impact on the cost you pay for borrowing money. Loan payments are made up of interest and principle (what you borrow). A low interest rate loan is easier to repay because there’s less interest added to your monthly payment. Lower interest rates are highly sought after because you pay less money to the bank who’s loaned you money.

Interest rates on credit cards and loans aren’t set arbitrarily. Banks use your credit score – the number that measures your creditworthiness – as one of the primary deciding factors in setting your interest rate.

How Banks Use Credit Scores

Your credit score – FICO score, at least – ranges from 300 to 850. Higher credit scores are best because they indicate that you’ve handled credit well in the past and you’re likely to pay new credit on time. Lower credit scores demonstrate that you’ve made some big mistakes in the past and that you may not make all your payments if you’re given new credit.

Banks set interest rates (the APR or annual percentage rate) based on the risk you pose. The higher credit risk you appear to be, the higher your interest rate will be. (Or, if your credit score is really low, you may be denied.) On the other hand, if you have a low credit risk (represented by a high credit score), you’ll typically qualify for a lower interest rate.
– via About.com Money

A Real Life Example

It’s easy to hear all the talk about a good credit score, good interest rates, and wonder… how do all these numbers really add up? Take a look at the example below. A money blogger set out to discover just what missed bills would do to your credit, and what those changes in credit would do to your interest rate.

First, I found out where my credit stands today, which was as simple as logging into my online account. I was pleasantly surprised to see that my credit score is estimated to be 773, putting me squarely in the “excellent” range. My mom was very proud when I told her.

With that information in hand, I set out to discover how dings to my credit would affect the rate I would get on a 30-year mortgage.

What it would cost me to get the average mortgage

To figure out how much the average mortgage might cost me over the course of 30 years, I did some Internet sleuthing. Here’s what I found:

  • The average interest rate on a 30-year, fixed-rate home loan was 3.67%, according to April 2015 data from Freddie Mac, the most recent available.  With my current score, qualifying for this rate is realistic. I might be able to do slightly better, but let’s assume this is the rate I would get.
  • The average amount borrowed on a 30-year, fixed-rate mortgage was $294,900 in March 2015, according to data from the Mortgage Bankers Association.
  • Based on these inputs, I’d pay $191,955.18 in interest over the life of my home loan, according to an online calculator at Interest.com.

That’s a lot of interest even with “excellent” credit. Let’s see what happened when I “damaged” my credit score.

The average mortgage, with a month of unpaid bills

Using the credit tool my credit card provides, I selected “allow every monthly account to become delinquent” for 30 days. It’s not unreasonable that an emergency could cause paying the bills to slip my mind for a month. In fact, it almost happened once.

After clicking “simulate,” I discovered that a 30-day delinquency on all of my accounts could cause my credit score to drop to 694, a loss of 79 points. My credit score would still be good at this point, but certainly not excellent.

Out of curiosity, I decided to see how much other stumbles might hurt my credit score. I found that:

  • Allowing one account to become 60 days delinquent would drop my score by 47 points, to 726.
  • Allowing one account to become 90 days delinquent would drop my score by 73 points, to 706.
  • Adding a foreclosure to my credit report would drop my score by 73 points, to 706.
  • Adding five credit inquiries would drop my score by 10 points, to 763.

Next, I figured out out how much this fall from grace might cost me in interest rate terms. Dan Green, a mortgage expert and publisher of The Mortgage Reports, told me: “From 773 to 694, you’d be looking at an approximate 50 basis points (0.50%) increase, or $30 per $100,000 borrowed [per month].”

He also explained that if my score had been just slightly lower to start with, an 80-point drop would cost even more: “By comparison, from 750 to 670, you’d be looking at an approximate 100 basis points (1.0%) increase, or $60 per $100,000 borrowed [per month].”

I decided to base my calculations on the 0.5% rate increase because it was tailored to the rest of the other numbers I’m working with, but keep Green’s calculations in mind. A point drop of around 80 can affect interest rates differently depending on the lender and the credit score you’re starting off with.

Using the same loan amount as the example above but with a 4.17% interest rate (the original 3.67%, plus 0.5%), my online calculator showed that I’d be paying $222,402.98 over the life of a 30-year, fixed-rate loan.

That means that one bad month could effectively cost me $30,447.80. That’s a lot of dough for a one-month lapse.
– via NerdWallet

Where does your credit score stand now – do you need to get it higher?

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