The Cost of Borrowing With a Low Credit Score
Borrowing money from big banks isn’t free. Everyone pays interest on a loan, but people with lower credit scores typically have to pay more interest than borrowers with better credit. Banks assign interest rates to credit cards and loans based on the borrower’s credit score. Generally, people with low credit scores end up with higher interest rates and ultimately a higher cost of borrowing.
Credit Score Impact on Mortgage Rates
If you’re planning to apply for a mortgage soon, you should have an idea of what a bad credit score will mean for your interest rate and monthly payment, especially since a mortgage is such a long term commitment.
Based on numbers from myFICO.com’s Loan Savings Calculator, with a low credit score of 620, you would qualify for a 5.364% mortgage rate. On a $150,000 mortgage, you’d have a monthly payment of $839 and would ultimately pay $152,014 in interest. That’s more than the original home purchase price!
But, with a 660 credit score, you would qualify for a 4.388% interest rate. That would give you a $750 monthly payment on a $150,000 mortgage. You’d pay $120,028 in interest. Forty points isn’t a huge difference, but it would allow you to save $89 on your monthly mortgage and $31,198 on the total interest paid.
If you had excellent credit (above 760) and could qualify for the best rate of 3.775%, your monthly mortgage payment would be $697 and you’d pay $100,849 in interest.
Keep in mind these are just rate estimates. Your real interest rate will depend on other factors like your income, down payment, and points purchased.
The Effect on an Auto Loan
Auto loans are smaller than mortgages and repaid over a shorter period of time, so the monthly payments are smaller, but there's still an opportunity to save.
Consider a $30,000 60-month auto loan. With a credit score of 620, you might qualify for a rate of 11.121%. That would give you a monthly payment of $654. Once the loan is completely repaid, you’ll have paid $9,245 in interest.
With just a slightly higher credit score of 660, you might qualify for a lower 7.363% rate, giving you a $599 monthly payment. You’d pay just $5,951 in interest. And if you had an excellent credit score and qualified for a 3.77% rate, your monthly payment would be $549 and you’d pay only $2,963 in interest.
Credit Card Interest Rates
Your credit score also plays a part in your credit card interest rate, but less predictably so. Borrowers with excellent credit can often qualify for lower than average interest rates which allows them to pay off balances sooner. For example, consider a $5,000 credit card balance at 11% APR and the same balance at 18% APR. With a $150 monthly payment, it would take 3 years and 4 months to pay off the balance with the 11% interest rate. The borrower would pay just $928.80 in interest.
At 18% APR and a $150 monthly payment, it would take 3 years and 10 months to pay off the balance. But the borrower would pay $1,984 in interest by the time the balance is repaid.
Borrow Now or Wait Until Later?
If you’ve ever questioned whether it’s worth it to improve your credit score, now you see the numbers. A better credit score can shave hundreds of dollars off your monthly loan payments and thousands off the interest you pay. If you’re planning a major loan soon, it’s worth it to spend some time doing things that will rise your credit score.