Your credit score is the yardstick to measure your stability when it comes to taking loans from the loan sharks or banks. Whether you want to purchase a new car or buy a new home, often you assume that a good amount of savings will help you in the deal. Now, this is not entirely correct. You need grasp the importance of a credit score. It is always smart to use your credit card to make large payments and periodically clear them within deadlines. Before you do this you should make sure you have a good credit score so that you reduce your interest rate. For more information on repairing your credit report, check out the review of CreditRepair.com here.
What is credit score?
It is both beneficial and important for you to understand your credit rating. Let’s break it down in simple terms. When you use your credit card, you are actually borrowing money which you should ideally return (payback) within a fixed amount of time. A credit rating or score is a statistical 3 digit figure which is used to determine the chances of an individual paying back that borrowed money. So when the bank says you are eligible for a certain loan, they are actually using your credit score to determine whether you can pay back the amount.
Your credit score depends on the following factors:
- Previous Credit performance
- Current level of indebtedness
- Time for which the credit has been in use
- Type of Credit
- Pursuit of new credit
Why is it important or benefits of a good CS?
When you take a loan, your lender (say the bank) will send information to a credit bureau that makes these reports based on how well you have managed your debt clearance. Higher the score, the better off you are for future loans. Paying off debts in a quick and timely manner will boost your credit score.
Let us understand why a good credit score is important before you make a big purchase. So you want to purchase a new car. You have a certain amount of your savings but would require a loan to fulfill the rest. I will divulge a little financial theory for better understanding. A risk is always associated with any investment. If someone is lending you money, there is what we call a calculated credit risk. The money lender will add a risk premium to the borrowed sum of money and this will affect the rate of interest at which the sum is loaned out.
Your credit risk and risk premium are based on your credit score. A higher credit score will effectively lower your risk premium and therefore lower your interest rate of the loan. Consequently, your monthly premium gets lowered.
Here are a few mathematical calculations to show you how important having a good credit score is:
I take a loan of $1000 from the lender. My friend Tom takes a loan of the same amount. My credit score is 720 or above and Tom’s is 600. The lender charges 6% rate of interest p.a. on my loan and charges 9% on the same amount given to Tom. We both decide on a loan period of 1 year.
Case1: My Loan Calculation:
Interest p.a.: 6% which amounts to $60
Total sum to be paid off= $1000+$60= $1060
Monthly Installment: $1060/12=$88.33
Tom’s Loan Calculation:
Interest p.a.: 9% which amounts to $90
Total sum to be paid off= $1000+$90= $1090
Monthly Installment: $1090/12=$90.33
You might think, well that’s just $2 difference. Now think further, increase your sum to ten times the stated amount and for a longer loan period say 36 months for $10000.
Case 2: My New Loan Calculation:
Interest p.a.: 6% which amounts to $600 each year. So a total interest of $1800 over 3 years
Total sum to be paid off= $10000+$1800= $11800
Monthly Installment: $11800/36=$328(approx)
Tom’s New Loan Calculation:
Interest p.a.: 9% which amounts to $900 each year. So a total interest of $2700 over 3 years
Total sum to be paid off= $10000+$2700= $12700
Monthly Installment: $12700/36=$353(approx)
Do you see how the difference keeps increasing? This was just a simple interest calculation based on a small amount. Naturally, over a longer time period and higher loan amounts, your credit score will play a huge role. Not only will your monthly installments go up but also your total due will increase with a low credit score. Hence it is very important to have a good credit score.
How to improve your credit?
Well, your credit score is not only important for loan sanctions and interest rates, but it is a yardstick for a lot of other structures: approval of your new credit card; a mortgage; or even a new phone line.
Know your credit score. Apply for a credit report. Be aware of your credit transactions.
Pay off your loans quickly. Pay more than the minimum due amount each month.
Do not juggle debt using other credit cards.
Thus, it is crucial for you to fix credit before making the next big purchase. It is beneficial to you both in the long and short run of the process.