Interest rates can impact your cost of borrowing by a huge fraction. Loan payments comprise of interest as well as principal cost. The principal is what you actually borrow from the banks. A low rate of interest based loan amount is fairly easy to repay, since there is less amount of interest added to your monthly payment. Thus, lower interest rates are preferable and sought after since you have to pay less amounts to the banks.
The loan interest rates are not set arbitrarily. For determining the same, banks take help of credit scores. Credit scores are numbers calculated mathematically, keeping in mind various factors. These numbers can determine a person’s credit-worthiness. The credit score is the determinant of your interest rates.
How credit scores are used
The credit score of a person, also known as FICO score ranges between 300 to 850. The higher your credit scores are, the better. A higher credit score indicates that you can handle your credits efficiently and you can repay them in time as well. However, the lower your credit score is, the more mistakes are made on your part while handling your credit situation. You might have made some mistakes in the past or you might not have repaid your loan back in time.
Banks tend to set interest rates for each person differently, depending on the risk you pose to them. Your credit score thus determines what percentage of interest rate you deserve. The banks will set an Annual Percentage Rate based on you. Higher your credit score, lower will be your interest rate, and vice versa.
Credit score affects your loan rates
When it comes to loans, an average rate of interest is advertised by websites instead of a range of varying interest rates. Your good credit score can help you qualify you for a rate that is either at the same level as that of the advertised interest rate, or a percentage below the advertised rate. However, with a bad credit score, you might end up with a rate of interest far more than that advertised in the first place. In this case, you will only have to look for different banks and money lenders to provide you a lower interest rate. However, the interest rates will still be higher for you than average.
You can get a better understanding of the same with the help of an example.
If you are applying for a $200,000 for a 30 year mortgage, then there are going to be two scenarios
Let’s say you have a credit score on the higher end, i.e. 750-850, then your APR might be 3.50%. Which means you will have to pay about $910 every month. Which makes your total interest rate amount to be $126,600 (approximate).
However, if your credit score falls on the lower end, i.e. between 550 to 650, then your interest rate might be about 5.20%. Which means that you will have to pay about $1100 every month. Your total interest in this case will be $194,070 (approximately).