The interest rate you are offered by a lender has a big impact on the cost of borrowing money.
A lower interest rate makes taking out a loan or using a credit card less expensive because less interest is added to your monthly payment. Lower interest rates are highly desirable because you pay less money to the person who lent you money.
Interest rates for credit cards and loans are not set arbitrarily. Banks use your credit score to determine your interest rate.
Credit score vs. Interest rate
Your credit score is a number that measures your creditworthiness. It tells lenders how likely you are to pay your bills on time or repay borrowed money.
Higher credit scores are best because they show that you have handled credit well in the past and are likely to pay new loans on time. Lower credit scores show that you have made some big mistakes in the past and may not make all your payments when you get new credit.
You can have several different credit scores depending on who is doing the calculations, but your FICO score is the one most commonly used. These credit scores range from 300 to 850, with a score above 670 considered good and a score above 740 considered very good.
The interest rate you are charged for a loan is how banks make money and limit risk. If a bank feels you are more likely to default on a loan, it may want to charge you a higher interest rate so it can recoup more of the cost of the loan early on.
The better your credit score, the greater the risk you pose to a bank or other financial institution. This means the higher your credit score, the lower your interest rate.
How credit scores affect credit card interest rates
Credit card issuers provide a range of possible interest rates with each credit card offer.
For example, a card may advertise an APR of 13.99% to 22.99%, depending on your credit score. Your final APR would be somewhere in this range, depending on your credit score and other risk factors.
Card issuers won't specify what credit score will get you a certain interest rate. This isn't determined until you submit your credit card application. Generally, if you have a good credit score, you can expect a lower APR. If you have a poor credit score, you will receive a higher APR.
How credit scores affect loan interest rates
For loans, an average interest rate is often quoted instead of a range. If you have a good credit score, you may qualify for an interest rate that is at or below average. However, if you have a poor credit score, your interest rate can be much higher than average.
A higher credit score does not guarantee you the lowest interest rate. Mortgage lenders also consider other factors when setting the terms of your loan, such as.B. Yours:
- Credit report
- Debt amount
- Assets and savings
You can use a credit savings calculator to find out how much you can save on a loan based on your credit score. The calculator shows sample APRs and monthly payments for mortgage or auto loans with specific terms for different credit ranges.
You won't know what APR you'll be offered until you apply for and are approved for a loan. Different lenders may also offer you different interest rates. When you take out a loan, it may be worthwhile to get interest rates from several lenders, regardless of how high your credit score is.
How you can improve your interest rate
Banks are required to give you a free copy of your credit score if it results in you being approved for a less favorable interest rate. The credit score disclosure also includes some details about what affects your credit score.
For a FICO score, these factors include:
- Payment history: How often you made payments on time (or not) accounts for 35% of your credit score.
- Debt amount: How much outstanding debt you already have accounts for 30% of your credit score.
- Length of credit history: How long you've been borrowing and repaying money accounts for 15% of your credit score.
- Credit mix: The variety of credit accounts you have accounts for 10% of your credit score.
- New credits: how recently you have opened new credit accounts and how many you have opened accounts for the last 10% of your credit score.
To improve your chances of getting a better interest rate, you can spend a few months improving your credit score. This is especially important with a larger loan like a mortgage, where a higher credit score can reduce your monthly payment by hundreds of dollars. This can save you tens of thousands of dollars in interest over the life of the loan.