I remember the very first time I bought a brand new car for more than a decade ago. I was still a student then and have very little knowledge of personal finance.
In addition, I did not clearly understand how this FICO score works. I did not have an excellent FICO score back then, only good, but I was just really surprised when the car sales agent ran the numbers and showed me how much the monthly payment Â of the car is.
I was really surprised knowing that buying a car was not based on the value of the car but it was more on how much I can afford on a monthly basis. The funny thing is, if I can’t afford the 60 months payment with my budget, he would re-ran the numbers and showed me a different version, at that time, he was showing me a 72-month payment just to meet my budget.
I did not like the idea of a 6 years payment so I just increase my budget in order to meet the 5 years payment plan. It’s funny how this FICO score really affects the purchasing power of the consumer.
In a perfect world, it would be really nice if we can purchase everything in cash but for most of us this is not the case. We have to borrow money to buy big ticket items such as cars and houses. While having a good credit rating is just one of the factors to get loan approval, it is also one of the critical ones in terms of getting good rates. Having a low FICO score does not automatically barred you from getting loans. If you have a borderline FICO, a good paying job, very lengthy employment history, and willing to put a down payment, chances are creditors will still approve your loan. Â However, they are going to hit you really hard on the interest rates: the higher the interest rates, the less purchasing power you have. For illustrative purposes, letâ€™s assume the following scenario:
Scenario 1: The effect on Car purchases
- Monthly Payment: $400
- Years to pay: 5 years
|FICO Rating||Interest Rate||Purchased Value|
Please note that the true impact of a loan in your monthly budget is not how large the loan balance is but how much the monthly payment is. Thatâ€™s why when getting loans, creditor look at your debt-to-income (DTI) ratio, which is the comparison of your monthly debt payment against your monthly income. For example, if your monthly obligation is $1,000 and you make $3,000, then your DTI is 33% ($1,000 divided by $3,000) and based on the creditorsâ€™ underwriting criteria, the higher the DTI the higher the risk of defaulting on the loan. When you go to a dealership, you would notice that sales agent would ask you how much you can afford on a monthly basis not how much the value of the car that you want.
Using the table above, if your FICO score rating is FAIR, and you can afford to make $400 per month car payment for five years, then you can purchase a car worth $18,826. However, if your FICO is Excellent, you can actually purchase a much more expensive car, in this case $22,260 for the same $400 monthly payment with five years to pay.
Now, letâ€™s look at it this way. Assuming that you want to purchase a Honda Accord and it cost $22,260 but you can only afford to pay $400 per month for 5 years. If you have an excellent FICO score, you can actually drive that car away with no down payment. Now, letâ€™s say that there is another person who wants to buy that same Accord but in this case his FICO score is just FAIR, so the creditors would have to give him 10% interest rate. If his budget is also just $400 per month for five years, he would need to put in a down payment of $3,500 before he can drive off that car from the dealership lot. You see, having a low FICO score just cost that person $3,500 in this scenario.
Scenario 2: The effect on Home purchase
- Monthly Payment: $1,500 (principal and interest only)
- Years to pay: 30 years
|FICO Rating||Interest Rate||Purchased Value|
When it comes to home purchases, it has even a greater impact because of the length of the mortgage. The person with just FAIR FICO score can only afford to buy a house worth $280,000 while a person with an excellent FICO score can purchase a house worth $314,000 for the same monthly payment of $1,500. Of course, there are other ways to lower the interest rates by purchasing points. Also, FHA loans also provide good rates for qualified home buyers even if they have a low FICO rating. Assuming that the person with the FAIR FICO score wants to lower his/her interest rate by 1%, he/she would then have to purchase points. Generally, the cost of the points is the same percentage, in this case 1%, so the FAIR FICO person would need to fork out $2,800 (1% x $280,000). So in this scenario, it cost that person $2,800 for having a lower FICO score.
This is why we always have to make sure that we maintain good credit and keep our FICO score high. In other words, FICO Score = $$$$$$.