If you could choose between saving or squandering hundreds of thousands of dollars throughout your lifetime, the choice would be a no-brainer, right?
Unfortunately, too many Americans let their low credit scores make the wrong decision for them.
Your everyday financial practices contribute to your FICO score, which can range from 300 (not so good) to 850 (amazing!). This important number helps lenders determine how likely you’ll be to pay back any money they might loan you. Some contributing factors are obvious, such as paying all of your bills on time. Others aren’t, such as transferring revolving debt to new credit cards every time a better interest offer comes along.
The median FICO score is 723, according to CreditScoring.com. Even though that number isn’t dismal, it still would put you in a position of paying considerably more in interest than you would if your score were up in the highest levels.
The consequences of a low score can be substantial. To get a good sense of just how much your score affects your ability to borrow at a good interest rate, we looked at what different scores would get you for a typical mortgage and a car loan. What we found, as noted in the chart below, is that you might pay an extra $82,000 in interest on a $250,000 home loan or an extra $5,600 in interest on a $15,000 used-car loan.
“If you look at the total interest paid for a home with a 630 score—nearly a quarter-million dollars over the lifetime of the loan—you’re talking about enough money to buy a second house,” says Gail Cunningham, of the National Foundation for Credit Counseling. “There is always a cost to credit, and that cost can increase tremendously due to a low credit score.”
The difference in interest payments essentially boils down to how much the lender trusts you, based on your past transactions—and transgressions. Even if you’re a model of financial responsibility now, any moments of youthful fiscal abandon could come back to haunt you.
“Most items on your history remain there for seven years,” says Kelley Long, a certified public accountant and member of the National CPA Financial Literacy Commission, which offers free personal finance information to Americans at 360financialliteracy.org. “So if you defaulted on a loan six years ago, it’s still there affecting your score. Your score represents your history of paying companies what you owe them. If you’re historically good at that, a lender is more likely to give you money. If your history indicates a lack of paying what you owe on time, lenders will be more skeptical.”
In these times of high unemployment, the low score can add up to a double-whammy: Some businesses use this information to evaluate job applicants, and bad credit could cost you a great career opportunity. “They’re looking at this as an indicator of a candidate’s character and sense of responsibility,” Long says.
Given the high stakes, these recommended best practices will help you bring up a bad score—or keep up a good one:
Know your number. First, find out your credit score so you can see what work you need to do (if any) to boost it. Reviewing your credit report should be part of your annual financial checkup. You can get a free one once every 12 months from each of the three credit bureaus (Equifax, Experian and TransUnion) at annualcreditreport.com. Surprisingly, 62% of Americans don’t do this, according to a survey by the National Foundation for Credit Counseling. You’ll find out if there are any mistakes on your record and/or if someone has stolen your ID. The reports are free, but you may be charged a fee to find out your FICO score.
Pay the bills. This one is obvious, but you’d be surprised by how much of an impact a seemingly small slip-up—even missing a bill due date by one day—can have. That’s because a history of on-time bill payments accounts for 35% of your credit score. “Paying every bill on time and in full will save you tons of money down the road by avoiding debt and the resulting interest,” says Ken Lin, CEO of Credit Karma, which provides free credit scores and monitoring for more than 7 million customers. To make sure you don’t miss deadlines, sign up for automatic payments online or set up reminders to mail your checks several days before they’re due.
Limit your open accounts. Avoid the temptation to sign up for lots of store credit cards to get special deals. The discount savings may cost you a bundle down the road. “A high number of cards, with lots of closed accounts, can reflect badly,” says Ethan Ewing, a former Experian executive and current president of Bills.com.
Older is better. You do want to have a few open accounts to establish good borrowing habits, but it’s best to stick with one or two credit cards instead of frequently switching around. “The formula favors accounts that have been open for several years,” says financial expert Randy Mitchelson, who produces the DailyDollar newsletter. “They’re considered ‘seasoned accounts,’ and they carry weight.”
Stay under the credit-limit radar. How you use (or don’t use) your available credit accounts for another 30% of your score. “It’s important to keep a generous distance between your current balance and your limit,” Lin says. Just because it’s there doesn’t mean you have to spend it. And definitely don’t go over your limit!
Ask for help. It’s not unusual to get saddled with a huge unexpected bill, such as a hospital charge that isn’t covered by insurance. However, don’t ignore it in the hopes that it’ll go away. “In this case, you can call the hospital billing department, explain your situation, and ask them to work out a payment plan with you,” Long says. “This will prevent the bill from going to a collection agency, which causes a big fat black mark on your history.”
Get credit for rent. Experian includes on-time rental payments to help build a credit score. “This is very useful for recent grads or those with a minimal history,” Ewing says. “Ask your landlord or building manager if they can report on-time payments.”