The Effect of FICO Credit Scores on Wealth Creation

We all know that a good credit score can result in a better interest rate on loans but you may be surprised to learn that a bad credit score can affect you in ways you might not have thought about.  In addition to paying higher interest rates, a poor credit score can result in higher insurance premiums, denial for employment, or having to pay a security deposit when leasing an apartment or opening a utility account.

According to Fair Isaac, the company behind your FICO score, 35% of your score is based on your payment history; 30% on the amount and type of debt you have, 15% on how long your credit history is, 10% on new credit taken, and the final 10% on the various types of credit you use.  According to Experion, the national average credit score in the U.S. is 736.

Higher Mortgage Interest Rates

FICO and Loan Rate

FICO Score & APR for $150,000 30 Year Fixed Mortgage

In the table to the right, mortgage payments were calculated for FICO scores ranging from a low of 620 to a high of 850 for a $150,000 conventional 30 year fixed rate mortgage.  It is clear to see the lower your FICO score the higher your APR and the more you will pay for your loan.  For instance, let's take a look at someone with a FICO score of 630 versus someone with a FICO score of 780.  You will pay $140 more per month or an additional $50,474 in interest over the life of the loan. Another way to look at this by looking at the lost opportunity to use the money for other purposes like building wealth.  By investing the extra $140 per month, earning 6.5% for 30 years you could end up with $160,940.  Kind of puts a different light on how expensive bad credit can be.

Higher Auto Insurance Rates

According to the Texas Department of Insurance, drivers with the worst credit scores were 1.5 to 2 times more likely to file a claim for both auto and homeowners policies.  They also found that drivers with the best credit ratings were 40% less likely to be involved in an accident.  Someone with a poor credit score is going to pay between 20%-50% more for auto insurance than someone with good credit.  With the national average cost for an annual policy of $1438, that would mean an extra $288-$719 each year for auto insurance.

I recently lost my job and have been late on my bills.  Will my insurance premiums increase as a result of this?

Many states have introduced legislation allowing policy holders to opt-out of the credit based rating system in cases of extraordinary life circumstances that could affect your credit: military deployment overseas, serious injury to self or immediate family member, loss of employment for 3 months or more, death of a child, spouse, or parent, or identity theft.  Contact your insurance agent for details.

Higher Interest Rates on Loans

If you have a poor credit rating you will not qualify for that zero percent financing deal for that new car you are looking at.  You will have to deal with a sub prime lender who may charge interest rates up to 25% adding thousands to the cost of owning a car.

Higher Account Fees/Deposits

Cell phone provider Verizon charges a $400 deposit for new accounts where the customer has a poor credit score.  The deposit is refunded after 12 months provided all payments are made on time.

Utility Companies in Arizona are permitted by law to require residential customers with poor credit scores to pay a security deposit of no more than twice their estimated average bill.

Apartment Rental – States govern how much landlords can charge for security deposits but in general tenants with poor credit scores will pay a higher security deposit.  There are also ways for landlords to get around the limit on security deposits by requiring payment of first and last month's rent in advance for tenants that landlords feel are a risk to skip out and not pay last month's rent.

The good news is that you are not destined for a life of higher interest rates and fees if you have poor credit.

What can I do to improve my credit score?

  • Pay your bills on time
  • Keep oldest accounts open and use occasionally (pay balance in full each month)
  • Keep outstanding credit below 40% on total credit limit
  • The goal is to pay off credit card debt monthly
  • Check your credit report annually and fix errors

As you can see poor credit can not only cost you more each month in higher interest rates and fees but more importantly make it difficult to build wealth. By taking care of your credit score and using credit appropriately, you can literally save thousands of dollars each year that could be used to fund other goals such as a child's education or retirement.

What would you do with money you were able to save as a result of a lower interest rate?  Spend it or save it?

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