Loans 101: Credit scores and interest rates
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When it comes to borrowing, what do these 3 positive outcomes have in common?
- A lower interest rate
- A higher credit score
- An approved loan application
Quite a lot, actually! In fact, loans, credit scores, and interest rates are practically related. If you adjust one, it often impacts the others.
Your ability to get a loan with a good interest rate is impacted by your credit score. At the same time, the right loan could be used as part of a plan to improve your credit score.
How does all of this work? Here are 4 important things to understand about credit scores, interest rates, and loans:
- Understanding your credit score
- How to improve your credit score
- How your credit score impacts interest rates
- How to get the lowest interest rate on a loan
For many, the term “credit score” feels overwhelming, like a Google search that unearths more questions than answers. Yes, it’s an important topic to understand. But it doesn’t need to be complicated.
Your credit score typically ranges from 300 to 850. The number factors in past behavior to indicate how likely you will repay debt. Financial institutions (credit unions and banks) often use it as a factor to determine whether to give you a loan — and the interest rate you will pay if they do. Your credit score is basically the adult version of a report card on your financial trustworthiness.
Credit score vs. credit report
A credit score and credit report may sound similar, but they are two different things.
A credit report is like a statement of your payment history — loans, credit cards, and similar data. The three major credit bureaus providing these reports are Equifax, Experian, and TransUnion. You can check your credit report annually for free through the credit bureaus at www.annualcreditreport.com.
A credit score is a system for applying a “grade” based upon the data in your credit report. It’s not uncommon for your score to differ slightly from source to source. For example, a free credit monitoring service may come up with a different number than your financial institution. While there are other ways to calculate your credit score, a FICO (Fair Isaac Corporation) score is the most widely used in lending decisions.
What makes up your credit score?
According to myfico.com, your FICO credit score is based on 5 different factors:
- 35% payment history: The most important thing a lender wants to know is simple. Do you have a track record of paying your loans and credit cards on time?
- 30% amounts owed: Available credit is key. If you’re maxing out your credit cards or have a significant amount of debt, this may indicate you’re overextended and may be more likely to miss payments.
- 15% length of credit history: In general, a longer credit history can result in a better score. How long it’s been since you established or used accounts factors in, too. Your credit history is where you can show an established, steady track record of creditworthiness.
- 10% new credit: Each time someone does a credit check, it puts a mark on your credit. If you open several accounts in a short amount of time, it can represent a greater credit risk.
- 10% type of credit: Your mix of credit is the combination of the types of loans you have, such as mortgages, auto, credit cards, etc.
Check it out!
Learn more about breaking down your score with Numerica’s credit score workbook.
The better your credit score, the more doors may open for lower rates and new opportunities. But if you have bruised or no credit, living the life you want can feel out of reach.
And repairing your credit score? That can feel like a huge undertaking.
Don’t lose hope. Here are 5 ways to improve your credit score.
Pay bills on time
What’s the harm in being late? It could cost you a lot more than you think. Late payments not only result in additional fees and potential rate increases, but they could also ding your credit score.
Making payments on time accounts for approximately 35% of your FICO credit score. That’s why it’s important to at least make the minimum payment on your credit card bill each month. What should you do when you can’t pay your bills? One of the most important steps is to communicate with your creditors. You could learn of programs or payment options available to you. This not only provides possible pathways, but it could also help protect your credit from further damage.
The path to raising your credit score can start today. So, even if you’ve had some serious delinquencies in the past, don’t be discouraged. A recent history (24 months) of on-time payments carries weight. It’s a positive signal to credit bureaus that you are responsibly making on-time payments.
Know your capacity
When it comes to credit cards, know your limit.
What is your actual spending limit on each card before it’s maxed out? The amount of credit you have access to is called your available credit, and it’s another significant component of your credit score.
If all of your credit cards are maxed out, you don’t have available credit. A good target for a healthy credit score is to keep 70% of your total available credit free. This increases what is known as your capacity and reflects positively on your credit score.
Don’t worry if you’re not there yet, but move in that direction. If you need to pay down credit card debt or other loans, consider rolling a debt snowball.
Don’t open a lot of credit at once
Good thing: Having a mix of credit cards and loans.
Bad thing: Getting a loan and three credit cards in the same month.
Especially if you are just beginning to establish credit, opening multiple accounts in a short timespan is risky. Every time your credit is pulled, your credit score may see a slight drop.
While these points repair themselves over time as you make on-time payments, take a moment to consider if saving 5% off that new pair of jeans for an in-store credit card is worth the potential impact to your credit score. Only apply for credit when you’ve considered the impact.
Establish credit for the long haul
It’s important to establish a track record of success with credit.
In fact, having no credit can be considered just as risky as having bad credit. When you have no credit, you have no credit score, which means no history for lenders to evaluate. You haven’t shown a positive or a negative spending history, which could make you a gamble to back when you are looking for that house, car, or credit card.
Just remember, it can take 6 or more payments to generate any impact on your FICO credit score. This is a long journey, so establish credit and manage it responsibly.
Pro tip: If you’re just starting to build credit, consider opening a small balance credit card, and use it for a single, small recurring charge like Netflix. Don’t charge anything else. In 6 to 12 months, bam! You will have a credit score and no debt.
Know when to get help
Already made a few mistakes? That’s OK. You may not be able to divorce your credit score, but you can get counseling. Just don’t wait too long before talking to a professional to receive the direction and input to redirect you toward credit bliss.
Yes, it’s going to take time and work. But living your best life is worth it. The sooner you begin the process, the sooner you will be on the path to living well.
At Numerica, we can answer questions and connect you with partners like Balance. Balance provides free, personalized counseling to help you find solutions after a financial crisis. Whether setting up a budget or reviewing options for consolidating debt, call Balance today at 888.456.2227 for one-on-one counseling or info on a number of money topics.
Your credit score not only impacts whether you are approved for a loan, but higher credit scores typically translate into lower interest rates.
How interest rates work
Interest is the price tag you pay for a loan. The lender sets the price — or interest rate — they require. The higher the rate, the more you will pay for the privilege of borrowing the money.
Many factors go into an interest rate, but one of the most important is your credit score. Good credit makes the lender consider the loan less risky, often resulting in a lower interest rate.
Saving money over the life of your loan
Over time, the lower interest rate provided by a higher credit score can add up to huge savings. Tools like FICO’s loan savings calculator help illustrate the difference a FICO credit score can make.
Take, for example, a 60-month new car loan totaling $20,000. The total interest you are likely to pay on that loan varies widely depending on your credit. An estimate pulled from the calculator in March 2021 showed the best credit scores (720+) would pay around $2,000 in total interest for that loan, while a score of 650 would pay about $5,000. Have poor credit? A score of 600 was estimated to pay about $8,000 in interest over the five years of paying off the $20,000 car loan.
In addition to your credit score, there are many factors that influence the interest rate on your loan. Here are five:
- Type of loan: The interest rate on a 30-year mortgage will be much different than the rate on a 14-day payday loans. You can find a lender willing to offer you terms to finance any number of needs or purchases — student loans, auto loans, recreation loans, home equity lines of credit, credit cards, etc. Since the inherent risks and timeframes vary so widely depending on the type of loan, the interest rates do as well.
- Collateral: Collateral is one of 5 C’s in the loan process that many financial institutions evaluate when considering a loan. Collateral is something that is pledged as security for repaying a loan, such as a house or car. When a loan includes collateral, it typically results in a lower rate. Lenders may view a loan as less risky when collateral is involved, because the collateral value could be used to repay the loan in case of default.
- Down payment: When the borrower makes a significant cash investment toward the purchase price, it can lower the loan rate. A down payment is seen as reducing the lender’s risk since it gives you instant equity in the home. Because your home serves as collateral in a mortgage, any equity you bring to the table is valuable to a lender in the event of loan default.
- External factors: Economic factors such as supply and demand, world conditions like unrest or natural disasters, government factors like federal interest rates — all of these and more influence the rate a lender will offer.
Linked accounts (relationship rates): When it comes to loans, it’s worth checking whether the lender offers incentives based upon other products and services you may have with them. For example, some of Numerica’s loan products include opportunities for a discount on the interest rate. Already have another Numerica loan or credit card? That would be considered a “linked account,” and you may receive a lower rate. Agree to pay the loan automatically from a Numerica checking account? Ditto.
Do the math
Recently spotted: A bumper sticker that said, “Why put off until tomorrow what I can impulse buy today?”
Here’s why: When it comes to major purchases, the time you invest upfront could save you years of heartache and high loan payments. So before you buy a car or before you buy a home, do the math. Talk to experts you trust.
The time you invest now may empower you with:
- Wisdom to wait: Will a few more months of saving for a down payment make all the difference? What about a few more months of paying off debt to make room in your budget? Should you set aside time to improve your credit score first?
- Clarity: So you feel informed and confident about a major decision.
- The best deal: The time may be now to fulfill your dreams with a great purchase and the best possible loan.
The decisions you make today will impact your budget and well-being for years to come. As Benjamin Franklin said, “By failing to prepare, you are preparing to fail.” Too bad he didn’t write bumper stickers.
Here’s the legal stuff: This article is provided for educational purposes only and is not intended to replace the advice of a financial advisor, loan representative, or similar professional. The examples provided within the article are for example only and may not apply to your situation. Since every situation is different, we recommend speaking to a professional you trust regarding your specific needs.