How Does Credit Score Affect Interest Rate
When you think of borrowing money whether it is a home loan, vehicle loan, credit card, or installment loan, a crucial but critical factor that determines not just your approval but also the cost of your borrowing is your credit score. So, understanding how your credit score can affect the loan interest rate you receive is important for making educated decisions. Before diving into how a credit score can affect the loan’s interest rate, it is important to discuss credit score.
Understanding Credit Score
A credit score is a three-digit numeric representation that represents your creditworthiness and tells the lender if you can pay the loan amount. Credit score ranges from 300 to 850, a higher score means you have a greater possibility to get favorable loan terms and a lower score means will opposite it. A good credit score is calculated based on your credit history, like payment history, length of credit history, credit type you used, and credit inquiries.
The most common credit scoring models are FICO and VantageScore and these credit scoring models weigh the same factors, may do so differently, and lead to slight variation in scores.
How Credit Score Determines the Interest Rate
An Interest rate is a cost that is received by the lender on a loan amount and expressed as a percentage of the loan amount. Lenders apply interest on the money that is being borrowed to reduce the risk of non-payment. The higher risk situation includes the high interest rate thai charged on the loan amount, and your credit score is the main indicator of risk. A higher credit score means less risk and a lower score means higher risk.
So, let’s check how your credit score can impact on interest:
Excellent Credit Score
As per VantageScore ratings, the credit score between (781 to 850) is considered excellent. Borrowers with excellent credit scores can be seen as lower risk. Lenders keep these types of borrowers in a special category and offer them lower interest rates on different loans they apply for.
Good Credit Score
A good credit score falls between (661 to 780) and borrowers with such kind of credit score are considered low-risk but might not qualify for the complete lowest interest rate. They receive competitive interest rates and it is slightly higher than the borrowers with excellent credit scores.
Fair Credit Score
The Borrowers with fair credit scores (601 to 660) face a moderate risk of interest rate when they apply for a loan. As a result, the interest rate is high compared to the excellent and good types of credit scores. This is because the lenders expect a possibility of missing or late payment.
Poor Credit Score
Borrowers with poor credit scores (500 to 600) face much higher interest rates. Lenders consider them high-risk due to their credit score and past credit issues like late payments, or a history of default. Lenders receive high interest rates because this is a way for them to offset this increased risk.
Very Poor Credit Score
A very poor credit score range (300 to 499) represents the highest risk. Borrowers with this range of credit scores may struggle to get approved for loans, and if they are approved, might be charged high interest rates. In some cases, lenders might require collateral to approve the loan.
Why Lenders Care About Credit Scores
This is because lenders use credit scores to assess the likelihood that a borrower will repay a loan. Your credit score is a reflection of your financial behavior over time, and it proves a predictive tool for lenders to determine how likely you are to make payments on time and repay the loan in full.
For example, if your credit history shows late payments or payments with penalties, the lender might guess that you will struggle to pay the new loan on time, and this risk will be compensated by charging high interest rates on your loan, which provides the lender buffer in case of default.
How Interest Rates Can Impact Your Loan Costs
The interest rate on your loan affects the total cost of borrowing. With a low interest rate, you will pay less interest on a loan over the life of a loan. When you have a high interest, it will increase the total amount you will pay.
Let’s understand it with the help of an example:
Suppose you have a $20,000 vehicle loan at a 3.5% interest rate for five years. So, over the life of the loan, you will pay $1830 in interest. On the other side with high interest rates at 7.5% the same loan for five years will have $4073 as an interest.
In this way, we find a $2,243 difference between paying with high interest and low interest.
What are the Ways To Improve Credit Score
Pay Bills On Time
Your bill payment history is one of the most important factors contributing to your credit score. When you miss even a single payment or pay it with a penalty, it hits your credit score negatively. So to maintain your credit score, you should never miss a payment.
Avoid Opening New Credit Accounts
Do not apply for a new credit account that you are not required to. When you apply for a new credit account it results in a hard inquiry for your credit score which might temporarily lower your credit score.
Track Your Credit Report Regularly
It is very crucial to track your credit report regular basis because it allows you to find errors and then you can easily correct your errors. Not only this, you are allowed to get your credit report once a year from the major credit bureaus.
Limit Your Hard Enquiries
Hard Inquiries also play a great role in maintaining your credit score. Too many hard inquiries made by the lender or bank might hurt your credit. So, make an informed decision when you apply for a new loan.
Conclusion:
As we know a credit score is a powerful tool in the financial world and it influences the interest rates you receive on loans and credit cards. So, by understanding how a credit score can affect interest rates, you can make informed decisions and take protective steps to enhance your credit health. An excellent credit score can save you hundreds or thousands of dollars over time and provide access to healthy financial opportunities, making it well worth the effort to maintain your credit score.
