There is a reason your credit history is so important and it is more than to secure you new financing. Of course, you need good credit for any lender to consider you for new financing, however, one of the best reasons to keep high credit scores is to secure the best interest rates. There are a variety of lenders out there willing to lend to people with less than perfect credit, but when you compare the interest rates both parties receive, you will see the difference in good credit and bad credit.
Low Credit Equals a Higher Risk
Banks look at your credit score as a rating of your financial responsibility. If you have a low credit score, chances are you are financially irresponsible. What that says to a lender is that you are a high risk for default. If they choose to lend to you, they need to figure out a way to make up for that risk. If you default a few years from the date of the loan origination, the lender needs to determine how to make money during that time. The easiest way is to charge you a higher interest rate.
After looking at your credit report, a lender can tell the reason for your poor credit score. A few of the most common reasons include:
- Late payments
- Defaulted loans
- Excessive credit cards that you cannot keep up with
Lenders look at each reason differently. For example, if you have many late payments, the lender might not want to take a risk on you. They see your payment pattern and they do not want to risk having their money paid back erratically.
Defaulted loans are even worse in the eyes of the lender. If you have several defaulted loans in recent years, chances are a new lender will not give you a loan for fear of default on their loan. If you had a one-time occurrence that forced you to default, such as a sudden job loss or sudden illness and you can prove it, the lender might consider your situation based on the circumstances.
Collections and judgments have quite an impact on a lender’s opinion of your risk level as well. Whether or not they are old or new, the bottom line is that the lender needs you to pay them in order to get new financing.
Excessive use of your credit has an impact on how the lender views you, but it is not as extreme as late payments or defaulted loans. If you stretched yourself thin financially, your debt ratio might prevent you from receiving approval on a new loan. The lender bases your debt ratio on the minimum payments reporting on your credit. However, if you used up most of your available credit, a lender will look at you as financially irresponsible. In order to be safe, lenders prefer that you have no more than 20 to 30 percent of your available credit outstanding at one time. If they do provide you with new funding, chances are they will charge you a higher interest rate.
High Credit Scores Equal a Lower Risk
On the opposite end of the spectrum are the borrowers with high credit scores. These borrowers are the ones that lenders consider financially responsible. Most of the time, people with higher scores do not have late payments, defaulted loans, collections or judgments. They also have their credit utilization rate under control because they are financially responsible.
When a lender looks at a borrower with a high credit score, they look at the credit history to make sure there are good payment patterns occurring. They also look at the length of the credit history and how much credit is outstanding at any given time. They look at the entire picture, rather than just the score because the history itself can paint the picture the lender needs to see.
Typically, people with high credit scores have one or all of the following habits:
- They make their payments on time – Even if they make their payments slightly after the due date, they do not make payments more than 30 days late, as that is the point that the credit bureau penalizes your credit score for a late payment.
- They pay their bills in full – People with good credit scores also do not charge what they cannot pay off. They understand that they need their credit utilization rate as low as possible. Generally, they pay their credit card balance off in full each month. Some borrowers do have a small credit card balance, but it never exceeds 30 percent of their available credit.
- They have a long credit history. The longer you hold your accounts, the more there is for a credit bureau to rate. In fact, the length of your credit history is a part of the algorithm that computes your overall credit score. The longer you hold your accounts the better. This means that people with good credit scores keep their accounts open, even if they do not use them, just to enhance that portion of their score.
- They choose credit card types carefully. There are many different types of credit cards out there and it seems like consumers get a new offer every day. Not every card is created equal, though. Cards that offer low available credit, such as department store credit cards, quickly eat up your credit utilization rate because even a small charge can equal more than 30% of your available credit.
As you can see, the people with high credit scores have better financial habits, which is why lenders give them better interest rates. These people are not a high risk and could even provide the bank with more profits in the future with other loan products. People with low credit scores, on the other hand, pose a large risk to the lender and are unlikely to provide the bank with any future profits. In fact, they will probably give the bank a loss in the end because they show a history of having a hard time with keeping up with their payments on a regular basis.