How Credit Scores Affect Loans

Credit scores are ratings that combine a borrower's credit history into one number, usually ranging from low points in the 400s to high points in the 800s. The most commonly used score is the FICO score, which gives different weight to various types of loans and debt activity. Because the credit score is a summation of most credit history, many lenders use it as an immediate rubric when deciding what type of loan to approve for a borrower. A credit score can affect several very important aspects of the loan.

Length and Type

First, a lender will often decide the basic terms of the loan from the credit score, including the length and type. Few lenders are willing to give highly risky loans to borrowers with low credit scores. For instance, a borrower wanting to buy a house may have to pay a high down payment with a low credit score, since the lender will want more money up front. It may also be riskier for the lender to agree to a shorter loan with higher monthly payments the borrower may not be able to handle.

Interest Rates

Interest rates are one of the most important aspects of the loan, and one of the terms most commonly affected by credit scores. A good rate will lower both monthly payments and the total interest the borrower will pay. Lenders will charge lower rates to those with good credit scores. Of course, many other factors apply and lenders have preset limits on how low they will drop the rate, depending on the type of loan, but credit scores can make a difference.

Basic Formulas

Different lenders use different formulas to judge what loan terms to offer, so there is no easy, set rule that makes a particular credit score equal a particular rate or loan. Some lenders give their loan officers the ability to make decisions on rates in particular cases, too. A credit score 100 points higher than a previous score will often give a lower rate, but the rule is not absolute. Auto loan rates, for instance, can range from 7 to 20 percent based on credit history.

Loan Effects on Credit

Just as credit scores affect loans, loans affect credit scores. People with lower credit scores can improve their rating by managing credit carefully, not overextending themselves, and making steady, reliable payments on all present loans. This will gradually increase credit scores. But defaulting on a loan or making late payments can have a drastic opposite effect, often dropping credit scores quickly and eroding interest rate opportunities.