In recent years, a simple three-digit number has become critical to your financial life. This number, known as a credit score, is designed to predict the possibility that you won’t pay your bills. Credit scores are handy for lenders, but they can have enormous repercussions for your wallet, your future, and your peace of mind.

How Your Credit Score Affects You

If your credit score is high enough, you’ll qualify for a lender’s best rates and terms. Your mailbox will be stuffed with low-rate offers from credit card issuers, and mortgage lenders will fight for your business. You’ll get great deals on auto financing if you need a car, home loans if you want to buy or improve a house, and small business loans if you decide to start a new venture.

If your score is low or nonexistent, however, you’ll enter a no-man’s land where mainstream credit is all but impossible to come by. If you find someone to lend you money, you’ll pay high rates and fat fees for the privilege. A bad or even mediocre credit score can easily cost you tens of thousands and even hundreds of thousands of dollars in your lifetime. You don’t even have to have tons of credit problems to pay a price. Sometimes all it takes is a single missed payment to knock more than 100 points off your credit score and put you in a lender’s high-risk category. That would be scary enough if we were just talking about loans. But landlords and insurance companies also use credit scores to evaluate applicants. A good score can win you cheaper premiums and better apartments; a bad score can make insurance more expensive and a place to live hard to find. Yet too many people know far too little about credit scores and how they work. Here’s just a sample of the kinds of emails and letters I get every day from people puzzling over their credit:

“I just closed all of my credit card accounts trying to improve my credit. Now I hear that closing accounts can actually hurt my score. How can I recover from this? Should I try to reopen accounts so that I can have a higher amount of available credit?”

“How do you get credit if you don’t have it? I keep getting turned down, and the reason is always ‘insufficient credit history.’ How can I get a decent credit score if I don’t have credit?”

“I am a 25-year-old male who made a few bad credit decisions while in college, as many of us do. I need to improve my credit drastically so I do not continue to get my eyes poked out on interest. What can I do to boost my credit score fast?”

“I joined a credit-counseling program because I was in way over my head. But my wife and I plan on buying a house within the next three years, and she has expressed concern that my participation in this debt management program could hurt my credit score. What should I do to help my overall chances with the mortgage process and get the best rate possible?”

“I’m 33 and have never had a single late payment or credit issue in my life. Yet, my credit score isn’t as high as I thought it would be. What does it take to get a perfect score?”

What these readers sense, and what credit experts know, is that ignorance about your credit score can cost you. Sometimes people with great scores get offered lousy loan deals but don’t realize they can qualify for better terms. More often, people with bad or mediocre credit get all the loans they want, but they don’t realize the high price they’re paying.

What It Costs Long Term to Have a Poor or Mediocre Credit Score

If you need an example of exactly how much a credit score can matter, let’s examine how these numbers affect two friends, Emily and Karen. Both women got their first credit card in college and carried an $8,000 balance on average over the years. (Carrying a balance isn’t smart financially, but unfortunately, it’s an ingrained habit with many credit card users.) Emily and Karen also bought new cars after graduation, financing their purchases with $20,000 auto loans. Every seven years, they replaced their existing cars with new ones until they bought their last vehicles at age 70.

Each bought her first home with $350,000 mortgages at age 30, and then moved up to a larger house with $450,000 mortgages after turning 40. Neither has ever suffered the embarrassment of being rejected for a loan or turned down for a credit card.  But here the similarities end.

Emily was always careful to pay her bills on time, all the time, and typically paid more than the minimum balance owed. Lenders responded to her responsible use of credit by offering her more credit cards at good rates and terms. They also tended to increase her credit limits regularly. That allowed Emily to spread her credit card balance across several cards. All these factors helped give Emily an excellent credit score. Whenever a lender tried to raise her interest rate, she would politely threaten to transfer her balance to another card. As a result, Emily’s average interest rate on her cards was 9.9 percent.

Karen, by contrast, didn’t always pay on time, frequently paid only the minimum due, and tended to max out the cards that she had. That made lenders reluctant to increase her credit limits or offer her new cards. Although the two women owed the same amount on average, Karen tended to carry larger balances on fewer cards. All these factors hurt Karen’s credit—not enough to prevent her from getting loans, but enough for lenders to charge her more. Karen had much less negotiating power when it came to interest rates. Her average interest rate on her credit cards was 19.9 percent.

Credit Cards

Emily             Karen
Credit score                         750                  650
Interest rate                        9.90%            19.90%
Annual interest costs       $792               $1,592
Lifetime interest paid       $39,600        $79,600
Karen’s penalty $40,000
Emily’s careful credit use paid off with her first car loan. She got the best available rate, and she continued to do so every time she bought a new car until her last purchase at age 70. Thanks to her lower credit score, Karen’s rate was three percentage points higher.

Auto Loans
Emily                Karen
Credit score                      750                   650
Interest rate                    5.00%               8.00%
Monthly payment          $377                 $406
Interest cost per loan    $2,646             $4,332
Lifetime interest paid   $21,166            $34,653
Karen’s penalty $13,487
The differences continued when the women bought their houses. During the 10 years that the women owned their first homes, Emily paid $68,000 less in interest.

Mortgage 1 ($350,000)
Emily               Karen
Credit score                       750                   650
Interest rate                      5.50%               7.375%
Monthly payment           $1,987              $2,417
Interest (10 years)          $174,760         $243,020
Karen’s penalty $68,261
Karen’s interest penalty only grew when the two women moved up to larger houses. Over the 30-year life of their mortgages, Karen paid nearly $200,000 more in interest.

Mortgage 2 ($400,000)
Emily                Karen
Credit score                        750                   650
Interest rate                     5.50%                 7.375%
Monthly payment           $2,271                $2,763
Interest (30 years)         $417,616            $594,572
Karen’s penalty $176,956
Karen’s total lifetime penalty for less-than-stellar credit? More than $320,000.

If anything, these examples underestimate the true financial cost of mediocre credit:
• The interest rates in the examples are relatively low in historical terms. Higher prevailing interest rates would increase the penalty that Karen pays.
• Karen probably paid insurance premiums that were 20 percent to 30 percent higher than Emily’s, and she might have had more trouble finding an apartment, all because of her credit.
• The examples don’t count “opportunity cost”—what Karen could have achieved financially if she weren’t paying so much more interest.

Because more of Karen’s paycheck went to lenders, she had less money available for other goals: vacations, a second home, college educations for her kids, and retirement. In fact, if Karen had been able to invest the extra money she paid in interest instead of sending it to banks and credit card companies, her savings might have grown by a whopping $2 million by the time she was 70.
With so much less disposable income and financial security, you wouldn’t be surprised if Karen also experienced more anxiety about money. Financial problems can take their toll in innumerable ways, from stress-related illnesses to marital problems and divorce.

So, if you’ve ever wondered why some families struggle while others in the same economic bracket seem to do just fine, the answers typically lie with their financial habits—including how they handle credit.

Next Up : Credit Lessons #2 – How Credit Scoring Came into Being