Part I: What does a credit score mean?
I spend a lot of time talking about the importance of building a good credit score, but a lot of people want to know: What does a credit score mean?
In this blog post, I’m going to answer that question, taking a look at two factors:
- What does a credit score mean to a lender?
- What does a credit score mean in terms of monthly payments?
What does a credit score mean to a lender?
A credit score is designed to give creditors an answer to one question: “What is the likelihood that this borrower will be more than three months late on a payment within the next two years?”
A credit score generally ranges from 300 to 850. A borrower with an 850 credit score (a rarity) is considered the least likely to default on payments while a borrower with a 300 credit score is considered the most likely to default.
A credit score above 720 is considered wonderful. These borrowers will qualify for the best loans and interest rates. Anything below 660 is considered weak credit, and anything below 620 is considered bad credit. A borrower with a score below 620 is considered “subprime,” which tells the lender that the borrower is highly likely to default.
A person’s credit score is the single most important factor in determining whether lenders will approve your credit card application, mortgage loan, and car loan. Generally speaking, lenders look at four things when determining your creditworthiness:
- Your credit score.
- Your salary.
- Your savings.
- Your down payment (for a home or car loan).
A person with a high credit score and a modest salary would be much more likely to receive a loan than a person with a modest credit score and a high salary.
What does a credit score mean in terms of monthly payments?
We always say that on a $300,000 30-year, fixed-rate home loan, the difference between a 720 credit score and a 620 credit score is $589 a month, or $212,040 over the life of the 30-year loan. Though this statistic is certainly an accurate representation of the difference a great credit score makes, the truth is that interest rates change daily. During the peak of the credit crisis, a person with a 719 credit score (normally considered a great score!) didn’t even qualify for credit.
The interest rates on a loan are updated daily in tandem with the Federal Reserve’s adjustments. As well, different types of loans call for different interest rates.
According to MyFICO.com’s August 2 listing of interest rates, a person with the best credit score would pay $753 a month on a three-year $25,000 car loan; a person with a 620 credit score would pay $919, a difference of $166 a month or almost $6,000 over the life of the loan.
As you can see, if you want to qualify for a loan and receive the lowest payments, you should learn how to improve your credit score.
And next week, we will take a look at several other reasons to build credit in Part II: What does a credit score mean?
