Your financial reputation is encapsulated with a number: Your credit score. This three-digit score can mean the difference between having your loan application accepted, and having it rejected. Even after your loan application is accepted, your credit score will influence what interest rate you get. Over the life of your loan, this can mean a big difference. The difference is especially obvious when you are dealing with large amounts of money, such as what you borrow to buy a home, and long periods of time.
Consider buying a home for $200,000. Let’s say you get a 30-year fixed loan. If you are approved at 5%, your total pay back amount will be $386,511.57. You will have paid more than $186,000 in interest. But what if you had to pay a 6% interest rate? Now, the pay back amount would be $431,6767.38: You’d be paying more than $231,000 in interest. That’s a pretty big difference, due just to a single percentage point. Since your interest rate is determined by your credit score range, you can see how having a good credit score might start to matter.
Most credit scores are broken down into ranges, and then labeled to provide a general idea of whether your credit is “poor” or “excellent” – or anywhere in between. If you have an excellent credit score, it will be fairly easy for you to get good terms on any loan, as long as you have relatively low debt and sufficient income. Those with lower credit scores might have trouble getting approved for loans. When they are approved for loans, they have to pay for the increased risk that the lender is taking on by paying more in interest.
Credit scores are broken down into ranges for simplicity. Credit score ranges are variable, though. What is considered “good” in one type of economic climate may only be considered “fair” in another climate. As a result, you have to pay attention, to some degree, to market conditions. Before the financial crisis of 2008, you could get the best interest rate on a mortgage loan if you had a FICO credit score of at least 700. Now, in the summer of 2011, you need at least a 720 to even be considered for the best rates, and some mortgage lenders want to see a 740 before they give you the lowest mortgage rate.
The most commonly used credit scoring model is the FICO score. The FICO score ranges from 300 to 850. The higher your score, the “safer” you are considered in terms of lending. In general, you will find that credit score ranges are as follows:
• 760 and above = Excellent
• 700 – 759 = Great
• 660 – 699 = Good
• 620 – 659 = Average
• 580 – 619 = Poor
• Below 579 = Very Poor
As you can see, if your score dips below 580, you will have a great deal of trouble even qualifying for a loan. If you have a FICO credit score of less than 580, you might need someone with good credit to co-sign on your loan. If you are applying for a credit card, you might need to get a secured credit card, or find a co-signer. With such a low score, lenders are reluctant to take a chance on you. Indeed, FICO reports that those who have a credit score of between 550 and 599 have a delinquency rate of 51%. That’s a more than even chance that you will default.
You should understand that you can’t even get a FHA mortgage loan if you have a credit score of less than 580. Many lenders won’t even consider you for a mortgage if you don’t have a FICO score of at least 620. Even in that range, you might find that you will have to pay 8% in interest, meaning that your total pay off will be $528,310.49, with more than $328,000 paid in total interest. And that doesn’t even include property taxes and PMI.
Those with higher credit scores are more likely to be approved for loans – and enjoy better interest rates. Right now, someone with excellent credit can get an interest rate of 4.8% on a 30-year mortgage. Our $200,000 example means that you would pay back $377,759.06 total, with less than $178,000 of it in interest. That’s a very big difference over the life of your loan. Lenders are willing to offer this rate to those with higher credit scores because the risk of default is lower. Consider: FICO reports that only 2% of people with credit scores between 750 and 799 default on their loans. The default rate for those with scores between 700 and 749 is still only 5%.
Indeed, many lenders like to use a FICO score of 700 as a cut off for the better interest rates because there is a big difference in delinquency rate. Delinquency jumps from 5% to 15% for those with scores between 650 and 699. However, you can still usually find fairly decent rates with a “good” credit score that falls in the range between 650 and 699, especially if you are shopping for smaller loans, like car loans.
Those with credit scores of less than 650 will begin having difficult getting some loans. It really depends on the loan at that point, and the lender. However, it is certain that you will have to pay a higher interest rate, and once you reach 620, you will have to pay subprime interest rates, which are often quite high when compared with the prime rates offered to those with better credit. If you are shopping for a car, you might find a little more flexibility, but better rates are still to be had only by those with better credit. Here is myFICO.com’s breakdown of what you can expect in terms of interest rate (as of summer 2011) for different credit score ranges when you go to purchase a car:
• More than 760: 4.13%
• 700 – 759: 4.35%
• 680 – 699: 4.53%
• 660 – 679: 7.75%
• 640 – 659: 5.18%
• 620 – 639: 5.72%
Of course, you can pay higher rates for car financing as your credit score drops below 620. If you are forced into turning to payday loans or car title loans because you can’t get a credit card or a small loan from your bank, you could end up paying what turns out to be an effective annual interest rate of more than 300%, depending on the company in question.
Your credit score range can impact you in ways beyond just your loan interest rate. You might have to pay a higher security deposit if you are looking to rent. Some landlords will check your credit score, and decide not to rent to you if you seem risky. Or, if you are allowed to rent from the landlord, he or she may require a bigger security deposit – just to protect against you skipping payments. Many insurance companies charge higher premiums for costumers whose credit scores fall in a range that is less than “good.” Some banks may not let you open a checking account if you have poor credit. There are even consequences from TV service and cell phone service providers for those with lower credit scores.
The next most used score is the VantageScore, which was developed by the three major credit bureaus. It’s fairly straightforward with its ranges, and it is pretty obvious where you stand as to credit under this scale:
• 900 – 990 = A
• 800 – 899 = B
• 700 – 799 = C
• 600 – 699 = D
• 501 – 599 = F
Few lenders use the VantageScore, though. For those lenders that do make use of the VantageScore, the best rates are only available to those with “A” credit. Rates are progressively higher as you head down toward “F” credit. And, unsurprisingly, many people with “F” credit on the VantageScore scale are unable to get approval for loans altogether. A co-signer might be needed if you are even to have a hope of getting approved for a loan with “F” credit – and many lenders won’t consider you even then. Indeed, you will probably need a co-signer for “D” credit as well.
Your credit score is likely to fall into a broader range that describes your general creditworthiness. If possible, you want to strive to improve your credit score to the point where it is considered “great” on the FICO scale (above 700). Of course, even then, you may not always get the best loan terms. Improving your score so that you have “excellent” credit will mean that you can save money on interest, and that you have a better chance of successfully negotiating terms more favorable to you. On top of that, when you have better credit, you will have access to better insurance rates, and you will be more likely to see good deals on everything from bank accounts to housing to cell phone service.