Most of us have heard time and time again that we need to take care of our credit score. And most of us probably make an effort to do just that. However, if you fully understood just how much of an impact a credit score can have on your financial future, you very well might lose sleep over it. And frankly, that could be a good thing. Time is money, and the amount of money you will save by improving your credit score even a little would be well worth those fewer hours of shut-eye.
The reason most people do not worry enough about their credit scores is that they do not fully understand how much the interest on their installment loans impacts the total amount that they will have to repay. While this is also true for smaller personal loans, where it can really hurt you is in the case of home loans.
The easiest way to understand why is by looking at an example. Let’s say Bob has a FICO credit score of 630, which means he would get a 30-year fixed-rate mortgage at a rate of 5.22%. Let’s also say that Sally has a FICO credit score of 640, which means she would get a 30-year fixed-rate mortgage at 4.67%. So in this case, Bob has to pay about half a percent more in interest than Sally. That is unfortunate for Bob, but it shouldn’t be that big of a deal right? If they each bought a house for $150,000, then half a percent of that would only be $750. Bob would rather not pay that, but it is not the end of the world.
Unfortunately, Bob is in for some very bad news. Over the course of his loan, Bob will actually end up paying $18,095.86 more than Sally – how could that be!?
The Devil in the Details: Amortization
If you really want to bring out your inner nerd, you can feel free to play around a bit with the following equation: (i=interest, and n=number of payments): Total Monthly Payment = Loan Amount [ i (1+i) ^ n / ((1+i) ^ n) – 1)].
However, for those of us who do not want to revisit our high-school math classes, all you need to get from this equation is that it means that your first loan payment is mostly going towards paying just the interest on the loan. Only a very small amount of your first payment will go towards paying off the principal.
In our example, Bob would pay $825.52 every month for 30 years. However, $652.50 of Bob’s first payment would go towards just paying interest on his loan; only $173.02 of his first payment would go towards paying down the principal.
In Sally’s case, the monthly payment would be $775.25, and even though her payment is lower than Bob’s, the amount that she gets to pay off the principal is higher! When Sally makes her first payment, she will have paid off $191.50 of the principal. Poor Bob is paying more money every month to pay off less of his loan. This is the dark power of amortization. The reason that even a small increase in your interest rate can cause you to have to pay a lot more is that you not only have to pay more each month, you also have a smaller amount going towards paying off the principal amount that you initially borrowed.
In fact, in some cases, the amount a person pays in interest over the course of the loan can be even more than the money they borrowed! If Tom took out a similar 30-year fixed-rate mortgage at 6%, he would have to pay back the $150,000 that he borrowed plus $173,757.28 in interest.
Bearing all this in mind, let’s back-up to when I first introduced Bob and Sally. How much lower was Bob’s credit score? How many points lower could his score have possibly been than Sally’s for him to have to pay over $18,000 more than her?
Ten. Ten points. Bob had to shell out $18,000 more dollars than Sally because his score was just ten points lower.
Anyone who has looked into ways to repair and improve their credit score will notice that raising your credit score by ten points is very doable. And now that you have read this article, you know that it is well worth the effort!