Understanding Credit Scores

Just as your schoolwork determines your final grade in various classes, the information in your credit reports is used to calculate your credit scores. One of the most confusing things about credit scores is that there isn’t just one. Your credit score depends on the particular scoring model that’s used to calculate it. Companies can create their own scoring systems or use brand-name scores calculated by other firms, like the FICO (Fair Isaac Corporation) Score or the VantageScore.

Your credit score is different from the final grade you receive for a class because it isn’t figured once and filed away. Your credit score is calculated fresh every time it’s requested. Therefore, it’s a snapshot of your credit behavior up to that moment in time.

Poor credit may indicate that you’ve mismanaged your finances by making late payments or maxing out credit accounts. However, having too little credit history can also be a reason for having a low credit score.

Having poor credit means you’ll be viewed as a risky customer who may not repay a debt. You’ll either be turned down for credit or charged an interest rate that’s higher than the rate offered to a customer with good credit. Why? In exchange for taking a financial risk on a customer with poor credit, lenders protect themselves financially by charging higher interest rates, which means you have to make higher monthly payments.

How Much Can Poor Credit Cost You?

Dora has excellent credit and goes to her bank to apply for a $15,000 car loan. After a few days the bank’s lending representative calls her with good news—she’s been approved! She can borrow $15,000 at 4% APR for a term of four years, which makes her monthly payment $338.69. The total amount of interest she’ll pay on the loan principal is $1,256.92.

On the other hand, let’s imagine Dora didn’t have excellent credit and the bank charged her 12% APR instead of 4%. At this higher interest rate, her monthly payment would be $395.01. She’d pay a total of $3,960.36 in interest—or $2,703.44 more than if her credit was in good shape.

The larger a loan, the more poor credit costs you. Table 1 below shows different scenarios for a home mortgage of $150,000 paid over 30 years. Not having excellent credit means you could pay an additional $127,493.41 in interest—on top of the original loan amount of $150,000.

Table 1The Cost of Poor Credit

Credit status APR (percent) Monthly payment (dollars) Total interest paid (dollars) Cost of having poor credit (dollars)
Excellent 3.75% $694.67 100,082.42 $0
Good 5.00 805.23 139,883.68 39,801.26
Average 7.50 1,048.82 227,575.83 127,493.41
Table 1.8: Table 1 The Cost of Poor Credit

FLH-24

Other Ways Having Poor Credit Hurts Your Finances

Did you know that having poor credit scores can cost you even if you don’t want a loan or credit card? Here are five ways that having poor credit affects your personal finances:

  1. Paying high insurance premiums: In most U.S. states, insurance companies are allowed to factor in your credit when setting car and home insurance rates. Having poor credit means you’ll be quoted rates that could be double or triple the amount that someone with excellent credit would pay. That’s because consumers with poor credit have been found to file more insurance claims.

  2. Paying high security deposits: You may be asked to pay higher deposits for an apartment and for utilities such as power, gas, water, and phone accounts.

  3. Getting declined as a tenant: You could be turned down for an apartment or house to rent because property managers prefer tenants who demonstrate good payment history.

  4. Getting turned down for government benefits: You might not qualify for certain types of federal or state benefits that require a good credit history.

  5. Getting denied a job: You might be turned down for a job by an employer who requires a credit check. Employers can’t get your credit scores or see your entire credit report, but they can find out if you’ve had credit problems.

Finance Tip

To find out your credit score, you can visit the credit bureau websites mentioned earlier and purchase the information from them. You may also buy your FICO Score at myfico.com, or get several scores for free at creditkarma.com.