Does Your Credit Score Determine Your Interest Rate?
Interest rates are usually based on your credit score. Typically, the higher the score, the lower the interest rate – and the less it can cost to borrow money.
By Carla Fried | American Express Credit Intel Freelance Contributor
5 Min Read | November 1, 2021 in Credit Score
No business lends money for free. Every lender requires you to pay back what you’ve borrowed, plus interest, on a loan or credit card balance. The interest rate you’re charged is typically based on your credit score, which measures the level of risk you represent to a lender in paying back what you owe.
The higher your credit score, the more likely a lender will offer you a lower interest rate, and vice versa. In practical terms, the difference between a lower interest rate and a higher interest rate can add up to tens of thousands of dollars over the life of a large loan.
Lenders typically rely on a person’s FICO credit score when reviewing a loan or credit card application. FICO scores range from 300 to 850, with five credit score ranges from “very poor” (300 to 579) to “exceptional” (800 to 850). A variety of factors determine the terms of any financial deal, but your credit score is a key element in determining your interest rate. To give you an idea of how your credit score and interest rate could affect your finances in practice, let’s take a look at two common life events: getting a car loan and getting a mortgage.
Getting a car loan: Let’s say you plan to apply for a loan to buy a new car. According to FICO data as of September 2021, if your FICO credit score is at least 720, you may qualify for a 3.828% interest rate on a 60-month car loan.1 If your FICO credit score is between 660 and 689, you may qualify for an interest rate around 7.432%. For more, read “What Credit Score Do You Need to Buy a Car?”
What does that actually look like? A credit score interest rate calculator can help. Using a base loan amount of $36,000 for a new car – the recent average amount borrowed, according to Experian – FICO calculates the total interest owed at around $3,612 for the 3.828% interest rate and just over $7,200 for the 7.432% interest rate.2
That’s a $3,600 difference over the five years, with the higher interest rate translating to an extra $60 per monthly payment. The long-term cost can be even more: If you qualify for the lower interest rate, invest the $60 monthly savings in a Roth IRA, and then let that money grow for another 30 years, you would have more than $17,500 assuming a conservative 5% annualized rate of return.
Estimated Interest on a 5-Year $36,000 Car Loan, Based on Credit Score (as of Sept. 2021)
|FICO Credit Score||720-850||660-689||590-619|
|Fixed Interest Rate||3.828%||7.432%||14.729%|
|Total Interest Paid||$3,612||$7,212||$15,079|
Buying a house or refinancing a mortgage: Suppose you’re thinking about buying a house or refinancing. According to FICO’s interest rate credit score calculator and based on recent mortgage rates, a FICO score of at least 760 may qualify you for a 30-year fixed rate loan with a 2.5% interest rate. A FICO score between 680 to 699 places the interest rate at 2.9%.
That seemingly small difference in rates is anything but. Recently, the national average mortgage size for a home purchase was nearly $370,000.4 If you borrowed that amount at the 2.5% interest rate instead of the 2.9% interest rate, you would save nearly $30,000 in total interest payments over the life of the loan – $153,000 vs. $181,000. For more on refinancing a mortgage, read “Guidelines for When and How to Refinance a Home Loan.”
What if your credit score is not as high as you’d like? The good news is you have the ability to improve your credit score over time. Here are two ways to get started:
- Pay your bills on time. Payment history accounts for 35% of your overall FICO score. In terms of credit card bills, if you pay at least the minimum balance due each month, in all likelihood you will score well on this metric. Experts advise signing up for automatic bill pay for your credit card and loans to avoid missing payments.
- Don’t overuse your credit cards. Every credit card you’re given has a maximum credit limit, which is the biggest balance you’re allowed to owe. The amount of available credit you’re using is called your “credit utilization ratio,” and it accounts for 30% of your FICO credit score. As a general rule, if you keep your credit utilization ratio below 30%, you should do well on this metric.
It’s also advisable to monitor your credit reports from all three major credit bureaus: Equifax, Experian, and TransUnion. You basically have two choices for monitoring your credit reports: a credit monitoring service or on your own. Be on the lookout for errors that may cause your credit score to be lower. Also, look for unauthorized accounts or hard-credit checks. They can be signs of identity theft – in which your personal information has been used by a thief to apply for a loan or credit card in your name – and can make a mess of your credit score.
Free credit reports from the three bureaus are available at annualcreditreport.com.5 If you do discover a mistake, you may file a dispute to fix it.
Your credit score plays a large role in determining the interest rate lenders charge on loans and credit cards. A high credit score increases the likelihood you’ll be charged the least interest. In other words, boosting your credit score may save you thousands of dollars in interest payments.