Thursday, August 30, 2012

The Costs of Bad Credit Part 2

The cost of bad credit can be very high; provided a credit issuer will give you credit. Last week, we looked at the costs of incurring bad credit such as late fees and higher rates. This week we will take a look at who may lend to a risky borrower and the extended cost of bad credit.

A credit score indicates to the lender the likelihood of a loan being repaid. The higher the FICO score, the more likely a loan will be repaid. Often times, those with low scores are offered a higher (AKA sub-prime) rate for car, home, and other credit purchases. It would not be unusual for someone with a low rating to be offered a 10-14% or higher interest rate on a used car loan when the prevailing rates for someone with a good credit rating would be about 7% or less. That was prior to the recent recession. Lenders are much more conscious of the defaults in subprime loans that have occurred over the past 5 years. Many have stepped away from the subprime market completely. Thus, for many lenders, either you qualify for a loan or you don’t. The subprime loan is no longer an option for many traditional lenders or many borrowers.

There are still some institutions that will lend to people with slightly less than perfect credit; they are known as credit unions. Why? Because credit unions take a more holistic approach to lending to their members. The FICO Score is important, but is not the only factor considered when lending. A credit union may require a higher down payment of subprime borrowers and/or ask them to pay a slightly higher interest rate. They will look at the applicant’s employment; how long have they worked for the same company? How long have they lived in the same home or neighborhood? How has the member managed their credit over the past 24 months? The answers to these questions may increase or decrease the interest rate or down payment.

As an example, let’s say a FICO score of equal to or greater than 740 is the target score for the institution and someone in that score range will get a rate of 2.99% for a new car loan with zero down. In this case, if someone misses the target by a bit, say the member comes in at 680, the credit union would likely make the loan with a somewhat higher rate than the base rate to help the member. Instead of 2.99%, perhaps the loan would be for 5.50%.

In this case, a car loan of $15,000 applied for a borrower with a 740 score and a borrower with a 680 score, there is a 2.51% difference in the loan rate (2.99% APR vs. 5.50% APR). The borrower with the 740 score will pay only $934 in interest over a 4 year period where the borrower with the lower score might pay as much as $1,745; a difference of $811 over the four year loan term. The borrower may not only be required to pay a higher interest rate, they may have to come up with money for an additional down payment. Subprime borrowers are often called upon to have a higher equity in their security than those with preferred rates. That is an additional cost to the subprime borrower. That is money that has to come out of savings leaving the borrower with reduced liquidity. Another cost is the loss of earned interest on the money used for the down payment. Let’s say the borrower has to put up an additional $3,000 in order to qualify for the loan, $3,000 in a savings account at 1% APY for 4 years would have earned $125. That’s better than spending an additional $800 in interest expenses.

Avoid these increased costs by managing your credit correctly.
  • Pay your bills on time and pay more than the minimum when possible.
  • Pay down outstanding balances.
  • Avoid using your entire credit available limit
  • Only apply for credit when you want it. Don’t apply for a card just to get a discount!
  • Read your credit contracts. Don’t get caught in a consumer trap. 
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Are you planning on buying a home? This is one of the great times to purchase one. Loan rates are low and home prices are starting to rise!  If you are ready to buy, visit our next Homebuyer's Seminar here at the Meriwest Credit Union main office on Sept. 8th. Get all the details you need to finance your home purchase! 

Curious about rates? Here are some links to our current interest rates on consumer and home loans:

Auto Loans - New and Used

Home Loans

Equity Lines of Credit

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