Bad Credit Can Cost You Lots of Money

No one enjoys having a low credit score; it’s embarrassing to admit to friends and family.  For most people with poor credit, though, the real problem isn’t as much a concern with status as being turned down for loans and credit cards.  The average consumer may not even be aware of one other pernicious aspect of having poor credit – paying more money in many aspects of day-to-day life than people with good credit.

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Credit cards

People with less than perfect credit, if they qualify for a card at all, pay much higher fees in the form of higher interest.  Many consumers are more concerned with monthly payments rather than the overall costs.  The good news here for lower scored customers – just because your card is issued at up to 20% higher than a card to someone with good credit doesn’t mean your minimum payment will be higher.  Credit card minimum payments are typically based on a percentage of your balance rather than interest rate.

Despite the equality of minimum payments with your good credit counterpart carrying the same balance, you should be concerned about the long-term effects of higher interest.  Making the minimum payment alone will take you literally years to pay down a credit card.  The higher the interest, the longer it takes to bring a credit card balance to zero; as a result you are paying more money.  Consider the following examples:

On a $5000 balance, at an 18.9 percent interest rate (normal for a “good credit” customer), with a minimum payment set at 4%, it would take you 11.5 years to pay off the balance.  During this time, you are paying $3109.16 in interest.

Take the same $5000 with a 28% interest rate, the going rate for many “bad credit” cards.  Making only the minimum payment (4%), it would take you 16 years and one month to pay off this balance, and you would be paying $6669.19 in interest— or more than twice as much!

Of course, if you are paying down your balance every month to zero, you will not be paying any monthly interest.  Despite this, even if you do pay off your balance each month, you may still pay more for your card than those with good credit in the form of higher annual fees.  Some bad credit cards charge a $10 monthly fee, others are as high as $75 per year.  People with good credit, however, can qualify for no-annual-fee cards.

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Auto Loans

Auto loan rates are extremely low right now – if you have good credit.  Interest rates on auto loans for those who have bad credit can be as high as 20% (average subprime rates are 17.7%).  On a $20,000 car with a 48-month (4 year) term, your payments on a 20% interest loan would be $456/month.  Compare this to the same loan life with 2.5% interest  – the payment is $329.

For people with the poorest credit, getting a loan on a new car from a financial institution is not possible at all, leaving them prey to used-car financing, loans that always have higher interest rates. Marketwatch.com reported that used car owners often wind up more underwater on financing when driving a car off the auto lot then new car buyers, 131.1% vs. 110%, due to higher interest rates.

Larger down payments are often required for those with not-so-good credit.  While not necessarily a cost, as you would be paying this money towards the cost of the car in any case, higher down payment requirements can limit the price of the car for which you can qualify.

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Mortgages

While there are currently few commercial mortgage products for those with truly awful credit, FHA loans will accept people with a FICO score as low as 620.   The interest rates on such loans are typically about 1 percentage point more than loans for people with good credit (defined here as having a 740 score).

Interest paid over the life of a mortgage loan is often a good percentage (40%) of the original loan principal financed even when the loan is acquired with good credit.  Add even 1 percent to the rate, and you will be paying thousands of dollars more in total after the 30- or 15-year term ends.

Some loan comparisons:

  • A 30-year mortgage on $200,000 principal at 3.5% pays $898/month (principal and interest) for a total of $123,312 in interest over the life of the loan.
  • A 30-year mortgage on $200,000 principal at 4.5% pays $1,013/month (principal and interest) for a total of $164,814 in interest over the life of the loan.

One of the advantages of an FHA loan is that you only have to come up with a 3.5% down payment in order to qualify.  The disadvantage of FHA loans:  you will be required to pay a mortgage insurance premium – 1.75% of the loan amount added on to the principal.  In addition to the premium, you will be required to pay a monthly mortgage insurance payment along with the principal, interest, taxes and insurance each month.   FHA monthly mortgage insurance on a $200,000 loan would pay 1.35% annually or $2700/year = $225/month.

Insurance

At least 3 states have laws that prohibit the use of credit scores for calculating insurance rates – in the rest it’s perfectly legal.  Insurance companies have long documented the correlation between low scores and higher number of claims, and as a result charge more for premiums to people with bad credit.  Insurancequotes.com reported in October 2013 that drivers with poor credit pay twice as much for auto insurance as those with good credit.

Some insurance companies do random spot checks of credit every 3 to 5 years and adjust insurance premiums accordingly.   It’s not just auto insurance, though: Homeowners insurance premiums are also based upon credit scores.

Opportunity Cost

Besides the direct hit to your wallet with interest rates and insurance, those with poor credit pay higher costs in intangible ways:

  • Jobs.  Many employers pull your credit report when making hiring decisions.  Losing out on a job with higher pay because of credit directly impacts your income.
  • Education.  Oftentimes, earning more money depends on having more training and/or skills so returning to school may be something you wish to pursue.  However, if you depend upon financing your education, you may run into roadblocks.  Getting student loans with bad credit can be difficult.
  • Building equity in a home.  Studies have shown that for most Americans, their home is their biggest investment.  If you are unable to qualify for a home, you are directing your money towards rent rather than equity.
  • Loss of investment chances.  Due to the higher fees you are being charged in many ways, you miss out on the opportunity to put that extra money towards retirement.  
Posted in Credit 101
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