What Is a Credit Score and How Does Interest Work?
By Joe Messinger, CFP®
April 22, 2022
We hear the ads all the time–“Do you know your credit score?” The actors are just miserable because their credit score is “bad.” But, what is a credit score anyway? How is it affected by our actions? How can we improve it? Why should we care?
What are credit scores used for?
Credit scores and your credit report are all about your history, and they are used to predict your future.
Your FICO® score is a three-digit number usually ranging between 300 to 850 and is based on metrics developed by Fair Isaac Corporation. The higher the number, the more credit trustworthy you are believed to be. There are three major credit agencies in the United States: Equifax, Experian, and TransUnion.
You should make a habit of regularly checking your credit score and what is on your credit report. Each of the credit agencies is required to allow you to request your credit report at least once per year. Credit Karma is also a great FREE tool that can help you monitor your credit as well as provide you with insights on how to improve your credit.
Factors that determine your score include:
- Payment history
- The amount you owe
- The length of your history
- The types of accounts you have
- Any recent activity/new accounts
What makes a healthy credit score?
The goal in determining a good credit score isn’t to be debt-free, necessarily, but to make your payments on time and have a nice long history.
Healthy credit scores have a good mix of different types of loans–10% of the score comes from the credit mix. Types of loans can include credit cards, home mortgages, car loans, student loans, etc. The goal is to have a mix, and a student loan can be part of that mix.
Payment history makes up 35% of the credit score. Each time a payment is late or missed the credit score is negatively impacted. How many days was the payment past due? How many separate times was the payment late? If payment is made each and every time by the date it is due, then the credit score goes up.
How are credit scores used?
Credit scores are used by lenders like banks, credit card companies, mortgage lenders, and credit unions. In addition to those, credit scores are checked by landlords, cell phone companies, insurance companies, and utilities. All these companies are trying to determine if you are a good risk. Will you pay your bills on time? How low (or high) should the interest rate be that they charge you?
Your credit score and credit history will follow you throughout your adult life. It will determine whether or not you can borrow money for a home or car, and it will determine how much you will pay for that home or car.
Regular, on-time payments on debt can build a strong history over a nice length of time so that by the time a graduate is in their thirties, they have done the positive things to raise their credit score and buy a house for a lower interest rate.
If a payment amount is too high, it will negatively affect the debt to income ratio lenders use when figuring out how much money they can lend you. They’re looking at how much of your monthly income is already headed out the door.
If payments on debt are more than 30-days past due, the lender will report it to the credit rating companies. The drop in rating can stay on your credit report for seven years. Multiple missed or late payments will only make the problem worse.
How does interest work?
Per The Balance:
“Interest is calculated as a percentage of a loan (or deposit) balance, paid to the lender periodically for the privilege of using their money. The amount is usually quoted as an annual rate.”
In short: the bank gives you their money. They aren’t able to use it, and you need to pay them extra to make up for their loan to you.
Each month a portion of your payment goes to paying off the original amount of money you borrowed, the principal, and the rest of your payment goes towards paying off the interest you owe. Interest is expressed as a percentage that is charged on the principal. A simple calculator like this one can help you calculate interest.
Why should you care what the interest rate is?
With a higher credit rating, applicants can get a lower interest rate on loans for things like houses and cars. When the credit rating is good, the interest rate the bank charges is lower. They feel more comfortable that you will not default on your loan. They believe you are “good for it”–that you’ll be able to make the payments.
As a result, the difference of a lower interest rate can have a substantial impact on what you’ll pay over the life of a loan. Say you purchased a house for $200,000 with a 30-year fixed interest rate of 4%. You would pay $143,739 in interest costs. (Ouch, right?!)
However, if your credit rating was lower, that same loan could have an interest rate of 6%. Suddenly, the total interest over the life of the loan is jacked up to $231,676. Quite a substantial difference.
Credit scores can have quite an impact on our financial lives. They determine how much we pay for things. Paying attention to a proper balance of debt to income and staying on top of our debt payments will lead to a higher credit score and lower costs down the road.
You should make a habit of regularly checking your credit score, and understanding how different financial decisions may impact your score over time.
Updated April 2022
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