The True Cost of Bad Credit

Your credit is critical to your overall financial health for at least three reasons.

First, bad credit means you pay higher interest rates when you borrow money. Second, it can impact other expenses, like your car insurance, because some insurers figure that people who wreck their credit are also more likely to wreck their cars. And, third, it can hurt your ability to find work: Many employers also believe that those who aren’t responsible with their money might not be responsible with the boss’s either.

Is this fair? It’s debatable. But like it or not, these things are facts. So it quite literally pays to keep track of your credit and keep it in the best possible shape.

One way to get a sense of your credit is by looking at your credit score. The company that produces the most-used credit score, the FICO score, is Fair Isaac Corp., which also goes by FICO. You can use FICO’s Free Credit Scores Estimator to get an idea of how various mistakes in your use of credit can affect your score.

Several years ago, FICO also allowed us a peek behind the curtain and showed us exactly how badly common credit mistakes can mangle your credit score. A few examples of mistakes and their effects that FICO revealed at that time include:

  • Maxed-out card: This mistake costs 10 to 30 points for someone with a 680 FICO score, and 25 to 45 points for someone with a 780.
  • 30-days-late payment: 60 to 80 points, and 90 to 110 points
  • Debt settlement: 45 to 65 points, and 105 to 125 points
  • Foreclosure: 85 to 105 points, and 140 to 160 points
  • Bankruptcy: 130 to 150 points, and 220 to 240 points

The higher your score, the more points you’ll lose due to such mistakes. Keep in mind that a perfect FICO score is 850, and you’ll generally need a score of at least 730 to 760 to get the best possible rates on loans, depending on the lender.

Translating point losses into dollar losses

The most obvious reason to maintain a good credit score is that bad scores mean less access to credit and higher interest rates when you receive credit. Reduced access to credit means lost opportunities for you. Higher interest rates can cost you a ton of money.

Consider the mother of all debt: a home mortgage. Let’s say you’re borrowing $200,000 on a 30-year mortgage with a fixed interest rate.

Show up at the lender’s office with a credit score in the 620-639 range, and you’ll pay 5.34 percent interest. If you make minimum payments, your total interest bill for that mortgage will amount to $201,610. But if you waltz in with a score in the 760-850 range, you’ll only pay 3.751 percent and your total interest bill declines to $133,484.

That means that over the life of that loan, that lousy score cost you $68,126 — enough to finance your own business, put a kid through college or retire at least a year earlier.

By the way, the numbers above came from FICO’s Loan Savings Calculator. Check it out for yourself.

The opportunity cost of bad credit

An even more dramatic way of looking at the same thing is to consider the opportunity cost, that is, what money you spend today costs you in terms of the opportunity to have more money tomorrow.

Here’s what I mean: Going into our $200,000 mortgage with a lower credit score means a monthly payment of $1,116 compared with a $926 payment with a higher score. In short, the person with the higher score has the opportunity to save an extra $190 a month. If they use that opportunity wisely and invest that $190 monthly for 30 years and manage to earn 6 percent on it, they’ll end up with $181,343.93.

Those numbers came from the U.S. Securities and Exchange Commission’s Compound Interest Calculator. Check it out, too.

Bottom line? Bad credit is a very expensive burden. If more people realized that, maybe we’d have fewer lousy credit scores floating around out there. According to FICO’s numbers, about 44 percent of Americans have a FICO score below 700.

Of course, if you lose your job, can’t find another one, can’t pay your mortgage and can’t sell your house, there’s not much you can do to prevent getting behind. The same is true if you have a long illness and are saddled with huge medical expenses. But if you screw up your credit through carelessness or living beyond your means, you’re giving up more than a low rate on a mortgage. You’re mortgaging your future and risking your retirement.

How has your credit score affected your life? Share with us in comments below or on our Facebook page.

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