By Brenda Weathers Hargroves
Shortly after posting the article about credit secrets earlier this month, I was asked to talk a bit more about how credit actually works.
By way of quick review, your credit score is based on five factors: your payment history, how much you owe, how long you’ve had credit, the types of credit you have and the amount of newly opened accounts. Lenders use the FICO (Fair Issac Corporation) credit score to determine your creditworthiness. Do you qualify for a mortgage, car loan, credit card or any other type of loan?
Solid financial footing requires understanding what your credit score means. After all, according to famed football coach Vince Lombardi, “If winning isn’t everything, why do they keep score?”
FICO credit scores range from 300 to 850, with the following distinctions:
300-579 – Poor
580-669 – Fair
670-739 – Good
740-799 – Very Good
800-850 – Excellent
Why High is Better
For many lenders, 720 is the ceiling for the lowest available interest rate. Even if your score is higher, the rate remains the same. Now we know how the score is calculated and the breakdown from poor to excellent. So, why is this important?
Bottom line: Having a good credit score determines what stays in your wallet.
Higher credit scores qualify for lower interest rates on loans. Lower interest rates translate to spending less money. This becomes particularly important when considering how much you’re borrowing and for how long. Consider the example of taking out a $100,000 mortgage loan with a 30-year fixed interest rate. (Disclaimer: Mortgage loans are generally much higher than 100K these days, but let’s use this amount as an example with the understanding that the higher your loan amount, the more you will pay in interest fees.)
If you have good credit and qualify for a low interest rate, you will pay less in interest over the term of the loan than if you have a low credit score. In the example above, if your interest rate increases by just 2% because you have a lower score, you could end up paying more in interest than the original amount borrowed.
A low credit score can hurt you in many other ways besides when you are trying to buy a home. The same rules apply to all other types of loans (credit cards, student loans, car loans, etc.). The lower your score, the more you pay in interest. In addition, these days, your credit score is also a factor used to judge your character, as many potential employers and most landlords check your credit when you apply for a job or rent an apartment.
And, don’t make the mistake of thinking you can get around having a low credit score, or worse, no credit history, by paying cash. I knew a young man who didn’t believe in credit and always paid cash. When he tried to buy a condo, his 50% cash down payment offer was turned down everywhere he went. Why? Because no record existed that showed he paid his bill on time or his ability to pay the balance. It took him a year to establish creditworthiness before he could finally purchase his condo. This is an example of when cash is not always king.
The Best Way To Think Of Credit
I once read somewhere that credit should be thought of as rent. Just like you pay rent for a roof over your head, you similarly pay rent for money you borrow to buy something you can’t pay for in full at the time of your purchase. So, in a sense, having a good credit score increases your buying power.
I tend to look at it in the reverse. I think having a good credit score increases your ability to save. When you buy something on credit and can benefit from lower rates, you keep more money in your pocket. And by the way, if we’re talking about credit card debt, the ideal card is one that offers a rebate. The company will charge you interest, but you can offset some of that fee through their rewards program. Optimal usage occurs when you become in control of your debt to where you’re able to pay the entire amount when it’s due and you don’t accrue any interest charges at all. That way, you avoid this fee and get rewarded for your purchases.
A friend who used to work in banking once told me that credit card companies consider people who pay their bills in full each month, and take advantage of their rewards, deadbeats. The companies are paying these people to use those funds. Think about it. Credit card companies only stay in business because most people who use their services are not in this position. Therefore, the masses make up for ‘deadbeat’ losses. So, you know what that means. The goal is to beat the credit card companies at their own game.
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