Your mother was right: Your grades are your ticket to the good life.
When you’re an adult, three little numbers largely determine your access to credit and your ability to own a home, a car or start a business—and how much you’ll pay for those things.
Your credit score—the one number on a scale between 300 and 850—is a clue about your creditworthiness. The higher it is, the higher the possibility lenders will take a gamble on you. “Your credit score can be the difference between owning a home or not,” said Linda Ferrari, a San Diego-based realtor and author of “The Big Score: Getting It and Keeping It.”
Ferrari explained that she’s encountered homebuyers who make more than $1 million a year but have poor credit scores simply because they don’t have good credit habits. “People think credit scores are a reflection of how much money you make,” she said. “They’re not. They’re about how you manage your credit.”
Keys to the house
Credit scores are most important when it comes to mortgages, said Laura Walton, executive director of TCI Foundation, a nonprofit that provides financial education in Tucson, Arizona. When you see mortgage rates falling to new lows, remember that those rates are available only to people whose score tops 760, the top tier of the credit score scale.
The difference in interest rates is dramatic. At the top end, borrowers pay a rate of just 3.285 percent, but two tiers down, borrowers with a score between 680 and 699 pay 3.684 percent, according to myFICO.com.
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For a $300,000 loan, borrowers with the lower credit score would end up paying an additional $800 a year. It may not seem like much, said Walton, but according to myFICO’s online calculator, that’s $24,000 over the life of the loan.
“If you invested that $24,000 at 8 percent for 30 years, it becomes $91,000,” Walton explained. That’s a good chunk of change that could finance something significant in retirement.
Ferrari, the realtor, advises homebuyers to pull up their credit scores a few months before seeking preapproval on a mortgage. That way, if there are mistakes on a credit report affecting your credit score, there will be time to clear them up. Consumers could also elevate a not-so-impressive score by making on-time payments on loans or credit cards for a few months and by paying down credit card balances to below 25 percent of the credit limit (keeping in mind that a 0 percent utilization rate could actually hurt your score).
“The real estate market is more competitive than ever for buyers,” Ferrari said. “Even if you have a better offer … if you don’t have the pre-approval letter, you will not get the property.”
That’s not to say that you’ll automatically be relegated to the doghouse if your score is low. Mortgage lending goes in cycles. Sometimes, when credit is tight, low scorers are completely shut out of homebuying. But when conditions improve, those with low scores can still get into a house, albeit at a price.
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“Two years ago, if you had anything below 640, they’d tell you to go take a hike,” said Al Bingham, a senior loan officer with Academy Mortgage and author of “Road to 850: Proven Strategies for Increasing Your Credit Score.” But now, he claimed, “even some 600s out there are getting mortgages.”
Remember, even if homeownership is of no interest to you and you are simply looking to rent, your credit score still matters. Landlords routinely check them to decide if you will be a risk. “You might be turned down for a rental if you have a poor score, or you’re going to have to come up with a lot more security deposit,” Bingham said.
Not just mortgages
Want 0 percent balance transfers? Rewards points? Annual fee waivers? You’ll only get these credit card perks if you’ve got a sterling credit score. Credit card companies determine what interest rates and rewards to offer based on credit score.
Credit card companies also use scores to check up on you even if you are already a customer. “They’re looking for any adverse changes to your credit report,” said John Ulzheimer, president of consumer education at personal finance website CreditSesame.com. “[If there’s a big change], they many no longer want to do business with you under the current terms.”
You could see your interest rate rise with that company even if your accounts with that particular lender are up to date and pristine.
Less widely known is the use of credit scores in determining insurance rates. Insurers use credit scores to come up with a credit-based insurance score that is used to predict how likely a consumer is to make an insurance claim.
“Insurance companies really don’t want people to know how they utilize credit scores.”
“They found a correlation between low credit scores and high-risk behavior,” said Walton at TCI Foundation. Plus, a low credit score might indicate an insurance customer who doesn’t pay his or her bill on time.
In fact, according to Fair Isaac Corp., the company whose methodology is used to come up with FICO scores, 95 percent of auto insurers and 85 percent of homeowner insurers use credit-based insurance scores in states where it’s allowed.
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But there is no industry standard as to how these scores are used. “Insurance companies really don’t want people to know how they utilize credit scores,” said Academy Mortgage’s Bingham. “The cost for someone who has a credit score from 550 to 580 is about double as someone with a score of 780.”
Bingham’s firm surveys credit card and insurance companies to understand the impact of different credit scores. Some companies’ rates bounce around, while others don’t, Bingham said.
As is often the case with credit scores, however, unearthing exactly how can be a mystery.
—By Ilana Polyak, Special to CNBC.com.