This blog is all about what a credit score is, why it’s important, and what you can do to avoid bad credit.
What is it
A credit score is a numerical ranking for your credit worthiness. How is your credit worthiness decided? It’s simply a numerical scale ranking your likelihood to repay debts (credit card debt, student loan debt, mortgage, etc.). This is important because it tells other institutions how good you are at paying back loans. Institutions, like a car dealership, are more likely to give you a favorable loan if you have a good score. This is because a good score means you are good at paying back what you borrowed. Credit scores range from 300 to 850. To learn more about where credit scores came from, I suggest reading Suze Ormans book, Young, Fabulous, and Broke.
Why is it important
Having a good credit score is important because it means you will get lower interest rates for things like buying a house or car. This means you have lower mortgage and car payments, allowing you to buy things for cheap because you are good at repaying. This can save you 10s of thousands of dollars down the road, even if the difference in interest rate is small.
Check out the example below to see why:
400 Credit score scenario:
Let’s assume you are looking to buy a $250K house and you only have $20K. If you have a credit score of 400 (bad), you may get an interest rate on a house mortgage of 9%. For a loan of $230,000 at 9%, allowing you to pay the loan over 30 year, your monthly payments will be roughly $1,800.
740 credit score scenario:
If you have a credit score of 740 or higher (good), you may get a 4% interest rate on the same house loan. For a loan of $230,000 at 4%, allowing you to pay the loan over 30 year, your monthly payments will be roughly $1000. This is 45% cheaper then the 400 credit score scenario.
Over the course of 30 years, this difference in credit score will lead to savings of $288,000 ($800 a month x 12 months x 30 years) for the person with a higher credit score. This seems deceiving, because the interest rate was only a difference of 5% (9% vs. 4%). It’s important to understand how these small changes in interest rates add up.
How to avoid bad credit
So how do you avoid being in a scenario where you might have to pay a lot more money by having bad credit? To do this, pay your bills on time each month. When you miss a payment on a loan, your score drops big time. You can set up automatic payments with your banks to assure that your credit bill is paid on time. Also, build up an emergency fund that you can pull from if you find yourself close to missing a payment. To setup your budget such that you have an emergency fund, check out this blog. Diving into your savings account is worth it if it means avoiding a reduction in credit score. Another way to avoid bad credit is to not borrow more than you can pay. There are a lot of rules of thumbs on how much money you can afford to borrow, and we will discuss in later blogs. I also discuss tips/tricks on how to improve credit score in this blog. Make sure to check it out!