A credit score is one of the most important numbers in a person’s life. It determines the cost of major purchases like cars and homes. It is a deciding factor for landlords in picking renters and some employers use credit scores to find dependable workers. Unfortunately for borrowers, a favorable credit score is not easy to obtain. The economic crisis that began in 2008 forced lenders to raise their expectations for borrowers in the hopes of lowering their risks. The once “good” credit score of 680 has been devalued in favor of scores of 720 or more.
Credit scores range from 330 to 830 and the average score in the United States is 698. Even the nation’s top average score of 713 in New England is not high enough to qualify for the best rates on loans. This means that many Americans will find themselves spending hundreds or thousands of dollars more for cars, homes and other major purchases.
The Dirty Secret
Lenders evaluate FICO scores based on a tiered system that divides credit scores into five ranges. Scores below 620 are often considered subprime, and borrowers in this range will either be denied loans or be offered higher interest rates and lower loan limits. For example, a non-profit state loan agency set 770 or higher as the top tier of FICO scores. Borrowers in this range received the lowest interest rates. In previous years, the same agency ranked 680 in the lowest tier in which borrowers were subject to interest rates that were 4.15% higher than those with scores in the top tier.
Borrowers with a FICO score of 689 were placed in the lowest tier. A score only one point higher, 690, was enough to be bumped up to the next tier and amounted to an interest rate that was 2.5% lower. These same dramatic jumps in interest rates can be seen in other industries such as home mortgages and car loans. Borrowers are encouraged to shop around for loans because each lender has their own “break point” between tiers. If you can find a lender that places your score in a higher tier, it could result in significant savings over the term of your loan. Another option is to find a co-signer with a higher credit score who would be able to get you placed in a higher tier.
So What Does That Mean?
Using the standards of the nonprofit state loan agency in the example above, imagine that you need a 6-month loan for $4,000. If your credit score is 689, you would be charged an interest rate of LIBOR (London Interbank Offer Rate) plus 6.45%. As of Nov. 17, the LIBOR rate for 6-month loans was 0.44%. Based on those numbers, the interest rate would be 6.89 %. If your credit score was one point higher at 690 you would be bumped up to a higher tier. Your interest rate would be calculated at LIBOR+3.95% which equals 4.39%. Individuals who have poor credit will often be subject to higher interest loans which they might not be able to pay off accordingly; as a result their credit becomes worse and worse untill they are no longer able to qualify for loans.
Some experts say that as the economy continues to improve lenders will gradually lower the benchmark for solid credit. In the meantime, consumers with scores in the lower tiers should wait a few months before applying for a loan, and follow basis financial advice such as paying bills on time, monitoring their credit reports and managing debt to help raise their scores.
The Bottom Line
The tier system of credit scores can be extremely fickle. One point can be the difference between hundreds or thousands of dollars in loan payments. With the higher expectations of lenders, it is more important now than ever to shop around for the best rates and make financial decisions that keep your credit score as high as possible.