Lenders make money off of the interest payments that they receive from customers that take out loans with them. So, what happens if customers do not make their monthly payments? Lenders lose money, plain and simple. But they have a way of recovering the money that they’ve lost. They simply charge higher interest rates to people who are more likely to default on their loan.

Here’s an example: Let’s suppose that a banker lends out $1,000 to eight different people (and they all have terrible credit scores). The banker hits all eight customers with high interest charges because he knows statistically that one of the eight will default on the loan. The remaining seven, who continue making high interest payments, will essentially cover the cost of the defaulted loan. The banker still makes money in the long run (‘cuz that’s what bankers do).

You may be wondering what all of this has to do with you. Well, I’m getting around to it; just give me a minute to share with you the statistics of defaulted loans in relation to credit scores. The following table will show you how banks (and other companies who extend you credit) calculate risk based on credit scores. The left column indicates credit scores and the right column indicates the odds that a person with that credit score will honor the loan.

Credit Score Range	Odds of Customer Repaying
Above 800	1292 to 1
760 to 799	597 to 1
720 to 759	323 to 1
700 to 719	123 to 1
680 to 699	55 to 1
660 to 679	38 to 1
620 to 659	26 to 1
500 to 600	8 to 1
Below 500	Too Risky – No Loan

Okay, let’s bring it home.  What does this have to do with you?  If your credit score is less than perfect, you will have to pay higher interest rates on all types of credit including mortgages, car loans, credit cards, personal loans, consumer loans and more. All of these higher interest payments can add up to a lot of money.

Don’t believe it?

Think about this: A $200,000 home at 6% will cost you $231,676.38 in interest payments over the course of a 30-year loan. Keep in mind that I’m only talking about interest here. This price does not include the $200,000 principle balance (so you end up paying $431,676.38 for a $200,000 home). A 6% interest rate is very good. In fact, it’s one of the lowest rates you can get. But what happens if you can’t get a 6% loan? What if you have to finance at 8% because of a poor credit rating? You will end up paying $328,310.49 in interest over the term of the loan. That’s a difference of $96,634.11. Can you afford to waste almost $100,000? (Unless you are Bill Gates, I assume the answer is an emphatic “no!”).  Most of us could put an extra $100,000 to pretty good use rather than giving it to some fat-cat banker.  (Like how about buying a couple of new cars, or paying for your kids’ college education, or retiring early?)

Bad credit scores can have a devastating affect on your credit card payments as well.  It’s simple. Folks with bad credit scores are charged high interest rates.  High interest rates cause your monthly payment to go up.  High monthly payments mean you will be paying the credit card companies tons of money. 

The fat-cat bankers get fatter….

But these are just a few of the obvious ways that a low credit score costs you money. In other articles we will take a look at some things that you may not have thought about.

As you probably know, your credit reputation has a credit score associated with it.  Credit scores generally range from 350 (which is a very low credit score) to 850 (which is an excellent credit score).  The scores and ranges depend on which scoring model generated the score (there’s a difference between a “FICO score” and an Experian score, for example).

Since FICO scores are the standard, and are the numbers that are generally used by lenders to evaluate your credit, we’ll use FICO scores in our credit score range example. 

Score Ranges	How Lenders Will View These Scores
720-850:	These are good to excellent credit scores.  Lenders see you as a moderate to low risk, and are more likely to give you a competitive interest rate on loans they provide. The higher your score, the better the rates you will enjoy, so credit repair can pay off (particularly if your score is below 810).
620-719:	These are fair to good credit scores.  In this credit score range, you will be considered a fair to good risk, but interest rates on loans will be higher.  You should work to improve your score by paying your bills on time, reducing your debt, and removing any negative items from your credit report.
350-619:	Sorry, these are bad to poor credit scores (don’t feel bad—Millions of Americans have bad to poor credit scores).  In this credit score range, you will have difficulty obtaining credit cards, lines of credits, or loans you need for a new car, a home, etc.  Improving your credit score should be an urgent priority.

The first thing that comes to mind when most people think about their credit is their “credit score”.  Just what is a credit score?  A credit score is a number that is calculated as an attempt to “grade” or rank your creditworthiness. The score is used by banks, lenders, utility companies, phone companies, and other businesses that are trying to decide whether you will be a good credit risk for them.  Put simply, companies use the number to decide if you will pay, and whether you will pay them on time.

Put yourself in a bank’s position.  How can they possibly evaluate thousands of loan applications from tens of thousands of people they don’t know, and figure out who is going to pay them back, and who isn’t?  It seems like an impossible task.  One approach would be to personally interview every loan applicant, and talk to each applicant’s friends and relatives to find out about the applicant’s credit reputation. 

That might work ... in the 1800’s. 

Now, it’s simply impossible to do this for every loan or credit application.  The solution has been to use credit scores as a grade or indicator of a person’s credit reputation.  The lender simply pulls a credit report for each applicant and uses the credit score to decide if a customer is a good or a bad credit risk.

So what makes up your credit score?  What goes into this magic number that allows lenders to decide if you are credit worthy?
The most widely used credit score is the “FICO score” created by Fair Isaac Corporation.  Lenders use FICO scores to help them make billions of credit decisions each year.  FICO scores are based solely on information in consumer credit reports. 

Your credit score is made up of a number of different components.  All of them are related to actions you make (or don’t make).  Two of the largest factors that go into your score are (1) the amount of debt you currently have, and (2) your payment history.  The amount of debt you have is relevant as it may show that you either have room to take on more debt, or you are “maxed out” and probably couldn’t safely add more debt and pay another lender.  Your payment history is relevant because it tends to show whether you have a history of paying your creditors on time (or, whether you have a history of late payments).

To learn more about how your credit score is calculated, how it is used, and how you can improve it, read more articles in this series.