Why You Need to Increase Your Credit Score

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So you have just gotten your credit score. All you know is what your credit rating is, but what does this mean for you and why does it even matter? How will a good credit score make your life significantly better than having an Average credit score? Without a pay bump, would having a, say, Excellent credit score do you any good?

Let’s have a look… 

Please note: The ranges and allocations may differ based on your location and the consumer credit reporting agency. For the purpose of this article, any differences are of no consequence. The principle is the core.

Scenario 1.

Excellent Credit Score

(720+)

Best interest rates and payment terms for loans

Scenario 2.

Good Credit Score

(680 – 719)

Competitive terms from lenders and mortgage originators.

Scenario 3.

Average Credit Score

(620 – 679)

Minimum credit score range to get fair terms.

Scenario 4.

Poor Credit Score

(580 – 619)

You can still get loans but only under your lender’s terms and at an increased interest rate.

Scenario 5.

Bad Credit Score

(500 – 579)

Your interest rate will be at least 3% above average.

Scenario 6.

Miserable Credit Score

(<500)

Getting any kind of financing is close to impossible.

How Does This Affect Your Borrowing, Practically?

Let’s look at an example of a house we want to buy:

We will keep it simple and not use too many data points (and make consistent assumptions) to make it easier to focus on the main point. Our considerations will include interest, Taxes, PMI, Insurance & Fees.

We are buying a house:

• Purchase Price: $250,000.00
• Period 20 Years

In each scenario, we will change only the interest rate and the required down payment. These are the only parameters your lender is likely to change based on how they perceive you as a lending risk.

(Please note that these rates are derived from US market-related rates. If the rates in your country vary, do not be alarmed. The principle still remains the same)

Scenario 1:

Interest Rate of 5%; Zero Down Payment

Total Monthly Payment                $2,197.81

Scenario 2:

Interest Rate of 6%; Zero Down Payment

Total Monthly Payment                $2,338.99

An Increase of $141.18 per month from Scenario 1

Scenario 3a:

Interest Rate of 7%; Zero Down Payment

Total Monthly Payment                $2,486.16

An increase of $288.35 per month from Scenario 1

Scenario 3b:

Interest Rate of 6%; Down Payment of 5%

Total Monthly Payment                $2,208.03

An increase of $10.49 per month from Scenario 1, but you have to raise a down payment of $12,500.00 before you get granted the mortgage. heavens forbid you use debt to raise this amount.

Scenario 4:

Interest Rate of 7%; Down Payment of 10%

Total Monthly Payment                $2,194.94

A decrease of $2.87 per month from Scenario 1 (you will be financing a significantly smaller amount, albeit at a higher interest rate), but you have to raise a down payment of $25,000.00 before you get granted the mortgage. Heavens forbid you use debt to raise this amount.

Scenario 5:

Interest Rate of 8; Down Payment of 20%

Total Monthly Payment                $2,006.21

A decrease of $191.60 per month from Scenario 1 (you will be financing a significantly smaller amount, albeit at a higher interest rate), but you have to raise a down payment of $50,000.00 before you get granted the mortgage. Heavens forbid you use debt to raise this amount.

Scenario 6:

Interest Rate of 10; Down Payment of 30%

Total Monthly Payment                $2,022.12

A decrease of $175.69 per month from Scenario 1 (you will be financing a significantly smaller amount, albeit at a higher interest rate), but you have to raise a down payment of $75,000.00 before you get granted the mortgage. Heavens forbid you use more debt to raise this amount.

So What Does All This Mean for You?

Now, let’s say we were to pair Credit Band 1 to Scenario 1, Credit Band 2 to Scenario 2, and so forth.

How would this affect how you thought about the different credit rating categories?

Let’s be clear, I am not a lender, so these scenarios are totally made up. What clearly emerges though, to me at least, is a compelling incentive to make having an excellent credit score a paramount priority.

Should You Delay Getting a Mortgage to Increase Your Credit Score First?

Pardon me, but this next part is quite involved, technical and has a lot of moving parts. But I have tried my best to simplify it without diminishing the principles I am trying to elucidate.

Okay! Let’s say your Credit Rating was Average. You want to get a mortgage even though you read my blog post, Your Mortgage is a Poverty Trap. Or perhaps because you read, Your Mortgage is a Poverty Trap, you were inspired to ask the bank to help you buy yourself an investment property.

If we were to use my examples, either Scenario 3a or Scenario 3b would apply to you, as your credit rating is Average. (the actual would be at your lender’s discretion, not so much yours because your credit rating it not exactly great)

We are going to try to see if waiting to improve your credit rating before you apply would be worth your while.

But because you are buying the house already (you are financially savvy, remember?), even though you have not let the bank in on your plan, you start to buy your house today even though you will only apply for a mortgage in two years’ time.

You will see what I mean below:

In Scenario 3a:

Total Monthly Payment                $2,486.16

An increase of $288.35 per month from Scenario 1

What if You Delayed Getting a Mortgage by 2 Years?

What if you were to put away your saving of $288.35 per month for 2 years while you advanced your credit from Average to Excellent, mostly by paying off debt? Remember, we said you start buying your house before the bank knows you are. We will assume that you will use what would have been your mortgage payment to pay for rent during this time to make this calculation simple.

Within only 24 months, you would have raised $6,920.40 (without any investment growth)

Let’s say you put down this $6,920.40 as a down payment now that your credit score has reached Excellent. Now the lender will charge an interest rate of 5% instead of 7%. You would have to delay the purchase by two years, but now you have significantly less debt in general and you are getting a lower interest rate on your mortgage, so all things considered, you are much more comfortable.

You also haven’t recommitted the funds that you previously used to service some of your debts, which you have now paid off, so you are simply putting that money away into additional savings or investments (although we will not consider these in this example to keep things simple).

Your down payment of $6,920.40 only reduces your monthly mortgage payment from $2,197.81 (original lender terms at Average credit rating) to $2,146.19 (a monthly saving of only $51.62 per month). Let’s say you add this saving to your monthly payments, choosing to pay the original $2,197.81. Your total of all payments would become $479,627.36 (down payment + extra monthly payments) as opposed to $492,785.84 (down payment only), a saving of $13,158.48 from making the extra payments alone.

If you had gotten the mortgage two years earlier under the terms the lender offered you while your credit score was still “Average”, you would not have had a down payment to present, nor would you have made any additional monthly payments. Your total of all payments throughout the mortgage period would have been $498,708.86.

By waiting to clean up your credit and saving for your lender’s original requirements anyway, paying a down payment up front, and making additional monthly payments, you saved $19,081.50 ($498,708.86 – $479,627.36). This is money you would have had to spend if you had accepted the terms that the bank offered you for your credit score rated “Average” two years prior anyway. This is a hugely significant saving!

What if You Invested the Money Instead?

Let’s put this on steroids.

Let’s say, you chose to invest this $288.35 per month through a vehicle that yielded a return of 7% per annum, throughout your mortgage instead of paying it into your mortgage. Without increasing your contributions year-on-year for inflation but rather keeping your contributions constant throughout the period you would have accumulated $146,348.11 at the end of this 20 year period.

Yes, you would now forgo the $19,081.50 saving on your total bond repayment by electing to contribute the funds toward an investment instead, but you would still be up $127,266.61 ($146,348.11 – $19,081.50) and you would own your property free and clear.

Please note: The percentage yield that the investment can deliver is higher (albeit marginally) that the interest rate percentage that your lender would charge. Please make sure that this is also the case in your country

Scenario 3b:

Total Monthly Payment                $2,208.03

An increase of $10.49 per month from Scenario 1 (Excellent credit score), but you have to raise a down payment of $12,500.00 before you get granted the mortgage.

What if You Delayed Getting a Mortgage by 2 Years?

What if you were to put away your saving of $10.49 per month for 2 years while you enhanced your credit from Average to Excellent, mostly by paying off debt? Remember, we said you start buying your house before the bank knows about it. We will assume that you will use most of what would have been your mortgage payment to pay for rent during this time to make this calculation simple.

Within only 24 months, you have raised $251.76 (without any investment growth)

Let’s say you put down this $251.76 as a down payment once your credit score is Excellent. Now the lender charges an interest rate of 5% instead of 6%. You would have had to delay the purchase by two years, but now you have significantly less debt in general and you are getting a lower interest rate, so all things considered, you are much more comfortable. You also haven’t recommitted the funds that you were previously using to contribute to servicing some of your debts, which you have now paid off, so you simply put that money away into savings or investments (to keep this simple, we will not even consider these funds).

Your down payment of $251.76 only reduces your monthly mortgage payment from $2,197.81 (original loan terms at Average credit rating) to $2,195.93 (a monthly saving of only $1.88 per month). Let’s say you added this saving to your monthly payments, choosing to pay the original $2,197.81. Your total of all payments throughout the mortgage repayment period would become $498,224.97 (down payment + extra monthly payments) as opposed to $498,546.52 (down payment only), a saving of $339.55.

But what of your forced down payment? You would have had to raise $12,500.00 according to your lender’s requirements. So really, your down payment would comprise:

• the down payment the lender prescribed,
• as well as the down payment you raised by putting away what would have been your monthly savings.

This would be $12,500.00 plus $251.76 that you saved over two years. That makes $12,751.76. This will give you a monthly saved amount of:

• $123.90 ($2,197.81 – $2,073.91). Applying this down payment to your new scenario, and choosing to pay an additional $123.90 per month (the amount you will be saving for the duration of the mortgage), as well as the extra monthly contribution of $1.88 per month (which was determined above), the total of all payments throughout the mortgage repayment period becomes $456,421.45.

If you had gotten the mortgage two years earlier under the terms the lender offered you while your credit score was still Average, you would not have had a down payment to present, nor would you have made any additional monthly payments. The total of all payments throughout the mortgage repayment period would have been $498,708.86.

By waiting to clean up your credit and saving up for your lender’s original requirements anyway, paying a down payment up front, and making additional monthly payments, you could save:

• $42,287.41 – ($498,708.86 – $456,421.45).

This is money you would have had to spend if you had accepted the terms that the bank offered you for your credit score rated Average two years prior anyway. The power of a significant down payment. This is a hugely significant saving!

What if You Invested the Money Instead?

Let’s put this on steroids.

Say, for instance, you chose to invest this $10.49 per month through an investment vehicle that yielded a return of 7% per annum throughout your mortgage, instead of paying it into your mortgage. Let’s say, now that your new credit rating no longer forced you to raise a down payment, you instead contributed your $12,500.00 lump sum towards your investment. Say you still generate a down payment of $251.76 from your two years of saving $10.49 per month which you contribute to your mortgage as a down payment. This would still reduce your monthly payments by $10.49 per month, which you choose to also contribute towards this investment. Without increasing your contributions year-on-year for inflation but choosing rather to keep your contributions constant throughout the period you would have accumulated $53,695.11 at the end of this 20 year period.

Yes, you would now forgo the $19,081.50 saving on your total bond repayment by electing to contribute the funds toward an investment instead, but you would still be up:

• $34,613.61 ($53,695.11 – $19,081.50)

, and own your property free and clear.

Please note: The percentage yield that the investment can deliver is higher (albeit marginally) that the interest rate percentage that your lender would charge. Please make sure that this is also the case in your country

Would You Wait?

Would you delay getting your mortgage by two years to make this kind of saving, all the while paying down your bond with more ease as you will have a smaller overall debt portfolio?

I know I would.

Also, check out these Related Posts;

This is How They Calculate Your Credit Score

Start to Fix Your Credit Now. Fast!

Calculator Used:

https://usmortgagecalculator.org/