By Liz Pulliam Weston MSN Money
The short version: Lower scores can cost you hundreds of thousands of dollars in extra interest and radically change the way you're able to live your entire life. Here's a scenario that can help you understand how.
Emily and Karen are friends who borrow about the same amount of money over their lifetimes:
Each gets $20,000 in private student loans to help pay for college.
College is also when they get their first credit cards, and they each carry an $8,000 balance, on average, over the years.
They buy new cars after graduation and replace them every seven years until they buy their last vehicles at age 70.
Each buys her first home with a $300,000 mortgage at age 30 and then moves up to a larger house with a $400,000 mortgage after turning 40.
Each takes out a $50,000 home-improvement loan to remodel the second house. But Emily has a FICO credit score of 750, which is considered good to excellent. Karen has a 650 score, which is considered fair to poor, depending on the lender.
Emily maintains her good credit scores by always paying her bills on time, applying for credit sparingly and never maxing out her credit cards. Lenders respond by increasing her credit limits and giving her more offers of credit, allowing her to spread her balances across several cards and further protect her scores.
The high cost of bad credit:
Karen, on the other hand, doesn't always pay on time and sometimes maxes out her cards, which makes lenders reluctant to extend more credit. She tends to carry larger balances on fewer cards than Emily, which further hurts her scores, and Karen has less ability to negotiate lower interest rates.
The following examples of what they pay are only illustrations. In real life, interest rates will wax and wane over time while the amounts paid for houses and cars will vary. But the illustrations will give you a pretty good idea of the potential cost of not-so-great credit.
The extra cost of a student loan:
Emily Interest rate 7.25%
Karen Interest rate 13.25%
Monthly payment $234 $302
Total interest paid (10 years) $8,176 $16,189
Karen's penalty $8,013
The extra cost of a credit card:
Emily Interest rate 10.99%
Karen Interest rate 19.99%
Annual interest paid $880 $1,600
Lifetime interest paid $44,000 $80,000
Karen's penalty $36,000
The extra cost of house No. 1:
Emily Interest rate 4.84%
Karen Interest rate 5.66%
Monthly payment $1,581 $1,734
Total interest paid (10 years) $132,592 $156,802
Karen's penalty $24,210
The extra cost of a car:
Emily Interest rate 5.78%
Karen Interest rate 13.24%
Monthly payment $481 $572
Interest cost per loan $3,843 $9,310
Lifetime interest paid $30,768 $74,480
Karen's penalty $43,712
For their second homes, paid for with a 30-year, fixed-rate loan for $400,000 over 30 years:
The extra cost of house No. 2:
Emily Karen
Interest rate 4.84% 5.66%
Monthly payment $2,108 $2,312
Interest cost per loan $359,004 $432,221
Karen's penalty $73,217
The total cost of Karen's lower scores? As a 30-year-old with a mortgage, car payment, student loan and credit card, she pays $372 a month more than Emily does for the same amount borrowed. Over a lifetime of borrowing, she pays an astounding $201,712 more.
It also doesn't count opportunity cost -- what Karen might have earned if she'd been able to invest the extra money she was paying to lenders. If you divided the $201,712 penalty over 50 years and figured an 8% average annual return, those interest payments could have turned into a retirement kitty worth more than…$2.3 million.
But mostly, the cost above doesn't quantify a lifetime of struggling with money. Because more of Karen's paycheck went to lenders, she had less money for everything else, from vacations to her kids' educations.
If you've ever wondered why some families flounder while others in similar circumstances don't, the answer could be (and probably is) rooted in how they handle credit.
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