To understand how a bad credit score affects your interest rate, you first need to know the different types of interest that exist, how lenders determine interest rates, and how they impact the cost of your loan.
The different types of interest can have different impacts on any loan you receive. By understanding the various types of loans, you will appreciate what happens to the cost of your loan when the interest rate is affected by a bad credit score.
- Fixed Interest
A fixed interest rate will not fluctuate during the term of your loan. It is the most common form of interest, and it’s easy to calculate, easy to understand, and stable.
- Variable Interest
Unlike fixed interest, variable interest fluctuates and is usually tied to the movement of base interest rates. Borrowers can benefit if the variable rate declines but end up paying more if it rises.
- Annual Percentage Rate (APR)
The annual percentage rate reflects the total cost of your loan, which includes the interest rate and relevant fees.
- The Prime Rate
Favored customers receive the prime rate from banks for loans. It’s relatively lower than normal interest rates and is tied to the U.S. federal funds rate (the rate banks use when borrowing and lending to each other).
- Simple Interest
Simple interest has a basic structure. It’s calculated using a simple formula: principal x interest rate x number of years = interest.
- Compound Interest
Unlike simple interest, which is calculated only on the principal, compound interest is calculated on both the principal and interest. It is calculated annually, and the interest amount is added to the loan balance, which is then used to calculate the next year’s interest.
Accountants refer to compound interest as “interest on interest” of a credit account or loan balance. An increase in this form of interest can have a greater impact on your loan compared to simple interest.
Now that you know the types of interest, here’s how your credit score is used in determining the interest rate on your loan. The pricing model lenders use to achieve this interest is the credit-scoring system and risk-based pricing.
The Credit-Scoring System and Risk-Based Pricing
Since the risk of a loan varies based on borrowers and other aspects of the loan, these two factors play a role in the pricing of loans, including the interest rate. Credit scoring systems, which were developed more than fifty years ago, offer a solution in assessing potential borrowers.
Lenders use sophisticated computer programs that assess borrowers and underwrite consumer credit—like credit cards, installment loans, mortgages, small business lines of credit, and home equity loans.
Credit scoring helps determine interest rates charged to potential borrowers and is commonly referred to as risk-based pricing, which helps lenders offer competitive prices on loans across many borrower groups. In this system, borrowers with good credit scores receive reduced prices on loans, while those with bad credit scores pay higher prices.
Here is how your credit score can affect the interest rate on different types of loans:
- Auto Loan Interest Rate
Based on the current interest rates on auto loans, if you have good credit, you can expect a rate closer to 4%. With poor credit, you will likely receive an interest rate closer to 16% or more.
Here is a general breakdown of the interest rates you can expect based on your credit score:
|Credit scores||Average APR for used cars||Average APR for new cars|
|781 – 850||4.69%||4.19%|
|661 – 780||6.38%||5.01%|
|601 – 660||10.91%||7.91%|
|501 – 600||16.78%||12.17%|
However, the interest rate can vary based on other factors besides your credit score, including:
- The term length of your loan
- Whether the car is new or used
The average auto loan interest rate in 2019 for a new car was 4.23% for borrowers with a credit score of 750+.
Car buyers with a high credit score can even get interest rates as low as 2%, showing just how crucial this score is in determining auto loan interest rates. This is further demonstrated in the fact that borrowers who have lower scores can receive five to ten times the interest rate of those with the best credit.
- Small Business Loan Interest Rate
For small business loans, interest rates will vary significantly based on credit scores, and lenders may not offer loans to borrowers with bad credit. Borrowers with excellent credit scores can receive interest rates as low as 3%, and borrowers with poor credit can receive a 5.5% interest rate.
Online lenders are more accessible to people with bad credit. Interest rates and loan terms vary based on the lender and loan products.
To appreciate the high interest rates that borrowers with bad credit receive compared to those with good credit, here is a sample of the rates that good credit borrowers might receive:
|Lender type||Average annual interest rate|
|Large national bank||2.55% – 5.14%|
|Small national and regional bank||3.23% – 5.40%|
|US branches of foreign banks||1.50% – 5.45%|
|Online/ alternative lenders||5.49% – 66.57%|
In contrast, here is an example of the interest rate variation that different lenders and different products will typically have based on borrowers with varying credit scores.
|Loan product||Average annual percentage rate for good credit borrowers||Average annual percentage rate for bad credit borrowers|
|SBA 7(a) Loan||5.85%||9.00%|
|Online term loan||7.35%||99.70%|
|Line of credit||5.25%||80.00%|
|Merchant cash advance||12.00%||200.00%|
- Personal Loan Interest Rate
Personal loan interest rates vary greatly based on your credit score, especially for unsecured loans, which rely more on your credit score than secured loans.
Borrowers with credit scores between 720 and 850 can expect an average personal loan interest rate of 9.8%. Borrowers with credit scores between 690 and 719 might receive an interest rate of 15%. Borrowers with credit scores between 630 and 689 may receive a 21.3% interest rate. Finally, borrowers with low credit scores between 300 and 629 can get a 28.2% interest rate or higher.
Fortunately, personal loan lenders usually offer funding access to people with bad credit.
- Mortgage Interest Rate
Interest rates on mortgages also vary based on a borrower’s credit score. Those who receive the lowest rates have a credit score of 760 and higher. With a poor credit score, you will not only receive a higher interest rate but also pay a more substantial down payment.
For Federal Housing Administration (FHA) loans, first-time buyers with a credit score of 580 or higher qualify for a 3.5% down payment. If your credit score is 580 or lower, you will need a 10% down payment.
Here is a detailed review of the rates borrowers can pay on a fixed-rate mortgage, based on varying credit scores.
|FICO score||Interest rate|
|760 – 850||3.64%|
|700 – 759||3.86%|
|680 – 699||4.04%|
|660 – 679||4.25%|
|640 – 659||4.68%|
|620 – 639||5.23%|
As you can see, a bad credit score will affect the interest rate on every loan option available. In some cases, you may not receive financial assistance if your credit score is too low.
By understanding the impact your credit score has on each loan, you will know how to select the best loans that offer the best value.