The interest rate that you are offered by a lender has a big impact on the cost of borrowing money.
A lower interest rate makes it less expensive to take out a loan or use a credit card, because there’s less interest added to your monthly payment. Lower interest rates are highly sought after because you pay less money to whoever has loaned you money.
Interest rates on credit cards and loans aren’t set arbitrarily. Banks use your credit score to help them set your interest rates.
Credit Score vs. Interest Rate
Your credit score is a number that measures your creditworthiness. It tells lenders how likely you are to pay your bills on time or repay money that you borrow.
Higher credit scores are best because they indicate that you’ve handled credit well in the past and are likely to pay new credit on time. Lower credit scores demonstrate that you’ve made some big mistakes in the past and may not make all your payments if you’re given new credit.
You may have several different credit scores, depending on who does the calculating, but your FICO score is the one used most often. These credit scores range from 300 to 850, with a score over 670 being considered good and a score over 740 very good.
The interest rate you are charged on a loan is how banks make money and limit risk. If a bank thinks you are more likely to default on a loan, it wants to charge you a higher interest rate so it can recoup more of the cost of that loan early on.
The better your credit score, the better risk you are for a bank or other financial institution. This means that the higher your score, the lower your rate.
How Credit Score Impacts Credit Card Rates
Credit card issuers disclose a range of potential interest rates with each credit card offer.
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. With a bad credit score, you’ll receive a higher APR.
How Credit Score Impacts 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. With a bad credit score, you may end up with a rate far above the average.
A higher credit score doesn't guarantee you the lowest interest rate possible. Mortgage lenders also consider other factors when setting the terms of your loan, such as your:
- Credit report
- Level of debt
- Assets and savings
You can use a loan savings calculator to find out 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.
You won't know what APR you'll be offered until you apply and are approved for a loan. Different lenders may also offer you different terms on interest rates. If you are taking out a loan, it can pay to get rates from several lenders, no matter what your credit score is.
How to Improve Your 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.
For a FICO score, these factors include:
- Payment history: Your history of making payments on time (or not) is 35% of your credit score.
- Amounts owed: How much outstanding debt you already have makes up 30% of your credit score.
- Length of credit history: How long you have been borrowing and repaying money for makes up 15% of your credit score.
- Credit mix: The variety of credit accounts you have makes up 10% of your credit score.
- New credit: How recently you have opened new credit accounts, and how many you have opened, makes up the final 10% of 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 higher credit score can decrease your monthly payment by hundreds of dollars. That can save you tens of thousands of dollars in interest over the life of the loan.