Many people love to say “I wish I knew that before I started getting credit”. What exactly do they wish they knew? Well, they wish they knew how expensive and life changing mishandling their credit would become. Your credit rating takes into account your entire credit history, and it takes a long time for negative items to roll off. That means that missing a mortgage payment three years ago may be the reason you are paying a higher interest rate on your new car today, or worse yet, why you were declined for credit.
When you get approved for your first loan, typically a personal loan or a credit card, you will get inundated with offers for other credit cards or loans. To many people in their late teens or early twenties, this seems like a source of freedom. This excess credit will help subsidize their income and allow them to live a lifestyle that they shouldn’t be able to afford. It starts with $1,000 here, and then can easily grow to $10,000 of credit card debt, a $20,000 car loan, $40,000 of student loans, and a $300,000 mortgage on a home that is underwater. The minimum monthly payments on these combine loans may be more than some families make on a monthly basis.
Over the past decade, the answer was to borrow your way out of debt. Simply refinance your mortgage or tap into home equity on your home that just doubled in value. Consolidating your debt seemed like something that made sense as it lowered your payment, reduced your collective interest rate, and afforded you a potential tax deduction with the increased home interest payments. The problem was that consumers were just kicking the can down the road. Debt has a way to continue to grow, and eventually it will lead to your inability to make your payments on a timely basis. When that happens, your credit score will drop drastically, and you will be left with a mountain of debt and no way to borrow your way out.
Even if you didn’t amass a mountain of debt, but only missed a few payments, that’s no big deal, right? Well, it’s definitely not the end of the world, but it will mean that your world is more expensive from now on. If you have anything less than an excellent credit rating, anyone who will loan money to you will want to ensure that they are adequately compensating for the risk they have lending to you. In other words, if everyone with a credit score identical to yours has a default rate of 10%, then that means the lender has to assume that you have a 10% chance of defaulting on your loan. If everyone with a credit score 50 points higher than yours has a 5% chance of defaulting, then that applicant has a lower chance of defaulting.
In plain English, the lower your credit score, the more likely you are to not pay your loan back fully. The lender is then taking a risk to lend to you, and as such, they will only do so at a higher interest rate.