The Hidden Costs of Bad Credit

NEW YORK (MainStreet) — It’s generally accepted that bad credit can cost you, but most consumers fail to consider how much they are actually paying in monthly interest rates, which are higher for borrowers with bad credit.

“When consumers consider their monthly payments, the price might not seem so bad,” Tom Quinn, consumer credit expert for Credit.com, told MainStreet. “But, when you look at the costs over the life of the loan, it adds up,”

To help illustrate just how much bad credit may be costing you, MainStreet used estimates from credit experts to see how much extra the average consumer would pay for a car loan, home mortgage and credit line with a 550 credit score vs. a 750 credit score.

Home Loan

Initially, we set up to compare how much someone with an uber-low credit score of 550 or below would pay compared to a member of the credit elite with a score of 750 or higher. However, experts quickly pointed out that someone with a score that low probably wouldn’t have to worry about higher interest rates since they weren’t likely to get a mortgage in the first place.

“Some lenders may try to argue this point, but there are really no published interest rates for a score that low,” John Ulzheimer, president of consumer education for SmartCredit.com, says.

This is because, as Ken Lin, CEO of Credit Karma.com points out, the minimum credit score requirement for a conforming loan – one that meets the terms and conditions determined by beleaguered mortgage giants Fannie Mae and Freddie Mac – is 620.

So, we moved on to plan B and looked at a consumer with the minimum required credit score of 620. According to Lin, a person with that score can expect to pay 6% to 6.5% interest on a typical mortgage. 

Comparatively, a consumer with a credit score of 750 would pay 4% to 4.5% interest on a typical home loan .

Now, if both applied for a $212,000, 30-year fixed-rate mortgage and our credit champion scores the lowest possible interest rate (4%) while the credit-challenged consumer gets the highest (6.5%).

Over the life of the mortgage, the high-credit consumer will pay a total of $364,363, with a monthly payment of $1,012. The low-credit consumer, comparatively, will pay $482,394 overall and his monthly payment would be $1,340.

In this example, bad credit can cost a prospective homeowner $118,031 in higher interest payments over the life of the loan.

“That could be the difference between a buying a house with three bedrooms over a house with two bedrooms when you were initially looking,” Quinn, who provided a similar estimate, points out.

Car Loan

Although he couldn’t get a home loan, our original low-credit consumer, Mr. 550, can get a car loan. The bad news is, he would probably be financially better off if he had been denied the financing.

“With a score like that, the interest rate is going to be around 18% to 20%, which is just brutal” Ulzheimer says. “It underscores how desperately you might need a car loan.”

Comparatively, Lin estimates that our high-credit consumer, Ms. 750, would pay about 4% interest on the same car loan.

Should both apply for a 5-year, $18,000 car loan, Mr. 550 would be saddled with a monthly payment of $477 and shell out, in total, $28,613 after paying back the loan. Ms. 750 comparatively pays $331 a month and the loan, in total, only sets back her back $19,890 overall. Or, in other words, they only pay $1,890 in interest while their credit-less counterpart pays more than $10,000.

Our mid-level consumer Mr. 620, who Quinn estimates will pay 11.9% interest on the same car loan, would end up paying $5,969 in interest since the total cost of the loan would reach $23,969 overall or $399 a month.

“That’s an upgrade, a maintenance program or a more robust insurance package,” Quinn says of the price gap.
Credit Card

Things get even scarier when Mr. 550 tries to sign up for a traditional credit card. According to Bruce McClary of Clearpoint Credit Counseling Solutions, someone with a score in the low 500s can get approved for a credit card, but it’s going to carry an astronomical annual percentage rate, or APR.

“These cards can have an APR as high as 36%,” he says. Comparatively, those with golden credit like Ms. 750 can net a card that has an APR as low as 8.9%.

Let’s say that both participants in our hypothetical study maxed out a $5,000 credit line. Ms. 750, who, let’s face it, probably would never carry any outstanding balance, would already have $445 in interest to pay off after only one month.

Mr. 550, on the other hand, would have to shell out an additional $1,800 in interest after only one month. That’s a difference of $1,355, showing how quickly a bad credit score combined with only minimum payments can dig a major debt hole.

“The higher interest rate is going to cause your balance to go nowhere when you are making only the minimum payments,” McClary says. “You’re going to be enslaved to that debt for a long time.”

Does a bad credit score already have you in a financial hole? MainStreet has some suggestions on how you can start getting rid of that debt in 2011. http://www.mainstreet.com/article/moneyinvesting/credit/debt/10-tips-reducing-debt-2011

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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