When applying for a loan or a credit card, the first thought that goes through people’s minds is “how much will it cost?” The total cost of a loan or a credit card is usually made up of the principal amount, interest rate, and other charges. That is why no matter how much you borrow or how much you spend on your credit card, the interest rate and additional charges will dictate how easy or difficult it will be to repay. Low-interest loans and credit cards are, of course, much easier to pay off than their high-interest counterparts. However, have you ever wondered what causes interest rates and charges to differ from person to person?The simple answer is — credit rating! Yes, your credit scores and credit history determine how much you have to pay as interest on loans and credit cards. People with high credit ratings have access to a myriad of low-interest loans and financial products. On the other hand, people with poor credit ratings may have to struggle when getting approval on loan applications. Even if they do get the approval, they have to pay hefty interests and charges for the loan. Limited options and steep interest rates go hand in hand with bad credit ratings. But why? Let’s dig deep and find out!
Good vs. bad credit – understanding FICO scores
Introduced by the Fair Isaac Corporation, the renowned data analytics company, FICO Scores are the most acknowledged form of credit rating present today. Your scores may range from 300 to 850. Typically, this model dictates that people with FICO scores of 670 have “good” credit rating, whereas anyone with a score of 800 or above has “exceptional” credit rating. Here’s a quick list that will give you a better understanding of how FICO scores vary and how they determine good credit and bad credit rating.
% of people with this rating
Impact on your ability to borrow
|800-850||Exceptional||19.9%||Lenders are always eager to lend you money. You will also get the lowest interest rates on loans and credit cards.|
|740-799||Very Good||18.2%||You have a fair number of loan options, and lenders are likely to offer you better than average interest rates.|
|670-739||Good||21.5%||You are likely to get decent interest rates. However, 8% of people with “good” credit scores are at the risk of becoming delinquent in the near future.|
|580-669||Fair||20.2%||You are considered as a subprime borrower. You may not get the best interest rates on loans and credit cards.|
|300-579||Very Poor||17%||You may not get approval on loan applications at all. You may have to rely on alternative lending or go for secured loans or pay high charges.|
Factors that can determine your credit scores
Whether you have an exceptional or very poor credit rating, you might wonder what contributed to your scores. Understanding what affects your credit scores is critical if you want to improve your ratings or maintain the same. The elements that determine your credit ratings may vary based on the scoring model in question. However, typically a number of factors in your credit report can influence your ratings. Some of these factors are:
- Total debt
- Credit utilization rate
- Credit card and loan repayment history including severity and number of late payments and penalties
- Age, number, and type of credit accounts
- Public financial records such as tax liens, civil judgments, and bankruptcy
- The number of newly opened credit accounts
- Number of credit checks and inquiries
Apparently, how you handle your debt and repayment determines how good or bad your credit rating will be. Timely repayment and efficient debt management can earn you great ratings. However, missing payments, late payments or defaulting can push your credit rating into a downward spiral. Improper debt handling and financial mismanagement are typically what causes low credit ratings.
How do banks and other lenders use credit ratings?
As mentioned above, having high credit ratings means you are eligible for just about every loan and financial product, and you also stand to get the most competitive interest rates in the market. To most banks and traditional lending institutions, you appear to be a responsible borrower who knows how to take care of his/her debts and finances. Having poor or very poor credit rating shows that you have made bad financial choices and paid your dues late or have not paid them at all. Most banks will reject your application because they deem you as a “high-risk” borrower.
Banks and other responsible lenders judge an applicant’s creditworthiness based on the credit scores. They also set the APR or interest rates depending on the risks you pose. High-risk candidates invite steep interest rates, whereas low-risk candidates get the most affordable rates. If you do not qualify for loans from traditional lending institutions such as banks due to reasons of low credit rating, you might have to rely on alternative lending solutions. You might find bad credit loans for all purposes, but even those loans may come with high rates of interest depending on your lender.
Good Credit Benefits – Better Rates and Terms
If you are thinking about applying for a loan or a credit card and feeling unsure about the interest rates you will find, you should first review your credit scores. If you have decent enough ratings to qualify for most traditional loans, you might get fair interest rates. However, if you do not meet the minimum eligibility criteria, you should look at alternatives such as short-term loans for bad credit or bad credit personal loans. It is also natural for you to wonder just how much interest rates can vary between people with good and bad credit scores.
Well, here is an example that should give you a simple explanation. Imagine two people with the exact same houses applying for the same mortgage of $300,000 with a 30-year fixed rate. Let’s call them Applicant X and Applicant Y. Now, Applicant X has a credit rating of 750, whereas Applicant Y has the rating of 620. Based on what we already know, Applicant X falls into the category of “very good” credit rating holder. However, Applicant Y barely touches the “fair” category. Due to the glaring difference between their credit ratings, Applicant X will get the best interest rate of 4.25% with $1,476 monthly repayment. However, Applicant Y will be offered a 4.75% interest rate and $1,565 monthly repayment.
Bottom line – Good Credit Benefits:
This is just a basic example that shows how interest rates may differ based on credit ratings. These numbers do not represent actual loans or interest rates offered by lenders. However, it is fairly apparent that having a good credit rating gives you the upper hand when getting loans or financial products.