Improve Your Credit Score to Save Thousands in Interest

by Kevin on July 29, 2011

In an ideal world, you have no debt. Your home, car, education and kid’s education, and lifestyle require no loans and no credit card. You finance nothing, you pay no interest, cash is truly king.

But we don’t live in an ideal world. Even if you have done a fantastic job of ridding yourself of student loans and not taking on credit card debt, it could easily take you a decade to save up to buy a home with cash. so most of us have some sort of financial lending in our lives. If you are going to have to utilize debt for whatever reason, you want to minimize your borrowing costs.

While you will read tips on how to clip a coupon here, save a dollar there, these pale in comparison to the impact of lowering your financing costs with a good credit score. I’m a big fan of earning discounts on your monthly costs (saving $10 per month on a cable bill), but lowering your interest rate by 0.5% on a big loan could save you the entire cable bill or more in costs.

Your Credit Score is a Risk Profile

Your credit score shows a lender how well you have managed your debt in the past. It seems financially backwards that to generate a good score you must have debt when the best thing for you financially is to have no debt at all.

Nonetheless, a low score will drive up your borrowing costs on every type of credit: home loans, car loans, and credit cards to name a few. You won’t get the best advertised rate and will instead pay higher interest over the life of the loan.

How to Improve Your Credit Score

Your score is determined by several factors including how much available credit you have, how much of that credit you are currently using and paying back, your payment history (if you have ever been late on a payment), how many lines of credit you have open, and how long you have had a credit profile.

A bad score is usually the result of mismanaging credit in the past – you were late on a credit card payment a few months or had to pay a fee to your car financing company. Or perhaps you are maxed out on all of your available credit. If your credit utilization is very high then lenders see you as a huge risk.

Improving your credit score won’t happen overnight. You must pay your bills on time, every time, for months on end to slowly repair your score. Setting up automatic payments can help you make sure you never pay a late fee again.

Additionally, drop your use of credit. If you have a credit card with a $10,000 limit and you currently have $9,000 that you are financing, stop using the card. You need to get your debt down so start chipping away at the balance. This will have the added benefit of getting you out of debt and limiting the interest you pay by not carrying the balance for years on end.

How Much Can My Credit Score Save Me?

Let’s look at two examples of utilizing credit to compare theoretical lending costs: buying a car and buying a home.

The Impact of a Credit Score on a Car Loan

Let’s say you need to buy a vehicle. Instead of doing the smart thing and saving up to pay cash, you opt to put 10% down and finance the rest. You buy a $20,000 vehicle, put $2,000 down, and finance $18,000. You opt for the 60 month/5 year term.

If you have a great credit score you might be offered 1.9% by the manufacturer. Over the 5 year term your payment would be $314.71. You would pay $882.77 in interest or about 4.9% of the total cost of what you borrowed.

On the other hand, a poor score could cost you 6.9% or more. At 6.9%, your monthly payment is $355.57, and the total interest paid jumps to $3,334.38 or 18.5% of the original $18,000 borrowed.

The difference between the two loans would cost you $2,451.61.

The Impact of a Credit Score on a Mortgage

While the impact on a car loan can be significant, you are still talking about a 5 year loan at the most. This limits the impact of interest rate because you are still paying down the principal aggressively. This is not always the case with a mortgage since many people get a 30 year note on their home.

Let’s assume you buy a $200,000 home and put 20% ($40,000) down. Your 30 year mortgage is for $160,000. With great credit you get the best interest rate available at 4.50%. Your monthly payment is $810.70 and over the life of the loan (if you don’t prepay any portion of the balance), you will pay $131,850.74 in interest.

Compare that to someone with poor credit who can only get a loan at 5.75%. The payment jumps to $933.72 and the total interest to $176,137.97.

The difference between the two loans? $44,287.23. That’s huge. So while I encourage you to find a way to save a buck here and there, if you ever plan to finance anything, especially a home, it is much more pressing to protect your credit score to minimize your borrowing costs.

And then once you have the loan, knock it out faster by prepaying on the loan as much as you can. But that topic is for another day.

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