From television commercials to Internet ads, it seems as though interest rates are advertised everywhere. It also seems as though these attractive interest rates are designated only for those with high credit ratings. A lender will almost never advertise their riskier borrower or average interest rate. No, the best rates are always reserved for those with the best credit scores.
However, if you’re like the average American adult, your credit score has taken a hit or two. From a late mortgage payment to a default on a loan, there are many reasons why your credit score might have suffered. If you are struggling like millions of other Americans, then those attractive rates you see advertised might seem as though they will always be out of your reach. The interest rate you are offered by a lender will be significantly different from what you saw on the ad.
Let’s say Person A and Person B are next door neighbors. Their houses are identical. Each couple wants to refinance a $300,000.00 mortgage with a 30 year fixed rate mortgage; however, there is one distinct difference. Person A has a credit score of 750, while Person B has a credit score of 630. Person A gets the advertised interest rate of 4.25%, and their monthly mortgage payment is $1,476.00. Person B, because of their credit score, is only able to obtain a 4.75% interest rate, which equates to a monthly mortgage payment of $1,565.00. Person B’s interest rate is ½ a percent higher, and their monthly mortgage payment is $89.00 more – all because of their credit score.
Person B actually has the option of getting the same interest rate as their neighbor, Person A, but will either have to pay points or a monetary fee. The cost is either 2 points or a $6,000.00 fee to obtain the same interest rate that their neighbor is receiving for free. This is just one example of how much your credit score can affect the interest rates you receive.
The practice is referred to as risk based pricing, and it has been an industry standard for nearly as long as credit scores have been used. According to the Consumer Financial Protection Bureau, risk based pricing happens when lenders offer applicants different loan terms or interest rates, based on the perceived risk that the borrower will fail to repay what they have been loaned. For example, if a lender believes that you are a high risk borrower, they will offer you a higher interest rate. Likewise, you will be extended a lower interest rate if you are perceived as a low risk borrower.
If Person B decided not to (or cannot) pay the points or the monetary fee for the lower interest rate, the additional expense will add up over time.
Person A and Person B are fairly close friends. They go to the same house of worship, and their kids attend the same schools. Once the kids have grown up and flown the nest, both begin to think about selling their homes to downsize. Let’s say that 15 years have passed. Both homes are expected to sell for around the same price. Person A has paid off $103,800 of their $300,000.00 loan and has made a total of $265,650 in mortgage payments. By comparison, Person B has managed to pay off $98,800 of their original $300,000.00 loan and has made $281,700 worth of mortgage payments. Because of their credit score, Person B has made over $16,000 more in mortgage payments, yet they have paid off $5,000 less on their mortgage than Person A! They’ve also paid $21,050 more in interest than Person A.
If you have more in common with Person B than Person A, there is good news. You can correct the negative aspects of your credit history that are currently affecting your credit score. The first step is to get a free copy of your credit report from AnnualCreditReport.com. Focus on fixing what needs to be fixed. Keep your current debts in good standing. Get sound advice from a reputable credit repair service, and keep moving forward.