How a Credit Score Influences Your Interest Rate
Interest rates have a big impact on the cost you pay for borrowing money. Loan payments are made up of interest and principal (what you borrow). A low-interest rate loan is easier to repay because there’s less interest added to your monthly payment. Lower interest rates are highly sought after because you pay less money to the bank who's loaned you money.
Interest rates on credit cards and loans aren’t set arbitrarily. Banks use your credit score – the number that measures your credit-worthiness – as one of the primary deciding factors in setting your interest rate.
The chart below illustrates the relationship between credit scores and interest rates, showing that – typically – the higher your score, the lower your rate.
How Banks Use Credit Scores
Your credit score – FICO score, at least – ranges from 300 to 850. Higher credit scores are best because they indicate that you’ve handled credit well in the past and you’re likely to pay new credit on time. Lower credit scores demonstrate that you’ve made some big mistakes in the past and that you may not make all your payments if you’re given new credit.
Banks set interest rates (the APR or annual percentage rate) based on the risk you pose. The higher credit risk you appear to be, the higher your interest rate will be. (Or, if your credit score is really low, you may be denied.) On the other hand, if you have a low credit risk (represented by a high credit score), you’ll typically qualify for a lower interest rate.
Credit Card Rates
Credit card issuers disclose a range of potential interest rates with each credit card offer. For example, a card may advertise a 13.99 to 22.99% APR depending on creditworthiness. Your final APR would fall somewhere in that range based on your credit score and other risk factors.
Card issuers don’t advertise what credit score will give you a specific interest rate. That won’t be determined until you make the credit card application. In general, if you have a good credit score, you can expect to receive a lower APR, or with a bad credit score, you’ll receive the higher APR.
Impact on Loan Rates
With loans, an average rate is often advertised instead of a range. If you have a good credit score, you may qualify for a rate that’s at or below average. Or, with a bad credit score, you may end up with a rate far above the average. Bankrate.com allows you to search for loans in your area based on your credit score. That will give you a better idea of the interest rate you’d qualify for.
MyFICO.com has a loan savings calculator that will show how much you can save on a loan based on your credit score. The calculator shows sample APRs and monthly payment for mortgage or auto loans with specific repayment periods for various credit score ranges. If you know your credit score already, the calculator can give you an estimate of the terms you can expect. However, you won’t know your specific APR until you apply and are approved for a loan.
Bad Interest Rate
Banks are required to give you a free copy of your credit score when it leads you to be approved for a less than favorable interest rate. The credit score disclosure will also include a few details about what’s driving your credit score.
To improve your chances of getting a better interest rate, you can spend a few months working to raise your credit score. It is especially important with a major loan like a mortgage where a low credit score can increase your monthly payment by hundreds of dollars and lead you to pay thousands more in interest over the life of the loan.