What is your credit score, and why does it matter?
No, I’m not (purposely) just quoting one of those recent commercials.
Your credit score is a number, generally in the range of 300-850 with higher being better, that reflects how well you’ve managed to make on-time payments of your debts. It doesn’t factor in your income, current debt level, or any other factors that may also seem important to someone offering you credit, but it is still used as a generic guideline of how likely you are to repay.
To make things more confusing, FICO – a corporation that is commonly used as a resource for calculating credit scores – updates their model every few years, but different financial institutions use different versions. So, in short, your credit score may vary depending on who is looking at it.
There are different ranges of what’s considered ‘bad’ or ‘fair’ or ‘good,’ but the score will likely affect your interest rate for whatever credit you may receive.
And in that way, maintaining a good credit score is like an investment.
Let’s put some numbers to this to understand the full impact:
After casually testing some scenarios on bankrate.com, the difference between a loan with a credit score in the low 600s and one with a credit score in the mid 700s can result in up to a full percentage difference in a 30-year loan rate. On a $200,000 loan at 4.5% the payment is about $1000/month, and at 5.5% the payment jumps by about $125 per month – basically a 12.5% higher payment.
You will have paid about $210k in interest over the life of the loan at the higher rate vs. $165k at the lower, or 27% more.
Looking at that another way, imagine taking that $125 per month and putting it in an investment earning 5% over the 30 years instead of blowing it on a higher interest rate – you’d have $100,000 at the end. For a house initially costing $200k, that’s a BIG difference!
I’m purposely saying this in a variety of ways so that at least one of them will shock you to the point that you realize that paying your bills on time is very important.
And depending where you live, $200k may be a low number for a loan on a house, so at $500k you can just multiply the above numbers by 2.5. Even more frightening.
This shows that the penalty for mistakes in paying your debts goes WAY beyond the late fees.
Not only will missing payments on your credit cards accrue late fees and affect your credit score, but the interest rates on those credit cards will also jump… hugely. Hopefully you don’t carry credit card debt, because it’s very expensive, but if you do then keeping your interest rate as low as possible can make a huge difference. I’m not even going to go into the math of credit card rates increasing because those numbers will get ridiculous quickly and just the mortgage numbers were scary enough.
The point is – pay your bills on time, because the penalties of not doing so can be lasting and enormous – far beyond the late fees.
-DD
Please be sure to also see our Theories on Money and Happiness:
Theory 1: The Iceberg Theory of Income
Theory 3: The Mountiain Biking Theory of Happiness
