Why is it so important to have good credit?
For most, two quickly answer your question, are a car and home ownership. But if you’re rebuilding credit and trying to atone for past credit mistakes, those two goals may seem far off. And, you may think, the logical starting point is a secured credit card or another minor move toward creditworthiness.
You may be right. Certainly, it doesn’t make sense to take on added debt you can’t afford. But, if your income allows, a car loan can provide unique value to help you rebuild your credit and achieve your goals.
You Need Credit to Build Credit
In order to get your creditworthiness back on track, you need to prove to lenders that you can responsibly manage a healthy mix of credit. Paying your monthly bills on time and in full will improve your score but opening up a new form of credit can add to your mix of credit and help you rebuild your score as you work to pay off your debt.
There are several factors to consider when deciding to take out an auto loan. The borrower should have a reasonable monthly income to support the monthly auto-loan payments. If the auto-loan payments are less than 18% of gross monthly income, the borrower is more likely to stay on budget and make reliable payments.
Additionally, the loan amount should be substantial enough to give the bank something to go off of when they review payment history. An amount over $8000.00 would be ideal. To build credit the borrower cannot miss any payments or send in late payments. The borrower should also keep the auto-loan open for at least a year, even if he or she has enough to pay off the loan sooner. Keeping the loan open shows a pattern of responsible payment history which is what builds a credit score.
Auto loans on your credit report
Your auto loan will likely affect your credit report and your credit score.
When you first look at your credit reports, you may feel overwhelmed by the data. To see your car financing, you can check Experian, Equifax, and TransUnion, that lists your car loan account and look at these two categories:
- Type of accounts: An auto loan is typically reported as an installment account. Other types of installment accounts include mortgage loans and student loans. Those are payments of the same amount, made for a set number of payments. Because a portion of your credit score is derived from “credit mix,” getting a car loan may help your credit profile if you don’t already have an installment loan.
- Current status: If you’re always on time with your car payments, your credit report will note that your car loan is “current” or “paid as agreed.” Because payment history has the biggest influence on scores, staying current on your payments could benefit your credit score significantly. Should you fall 30 or more days behind, you risk having your car repossessed by your lender and ruining your credit.
If you make all of your auto loan payments on time and your credit reports show that over time, great. But if an error pops up — for instance, an on-time payment is posted as late, consider filing a dispute.
Remember, you can get free copies of your credit reports every 12 months to make sure all your accounts are being reported correctly. You can check more often than that with NerdWallet’s free credit report, which updates weekly.
Rebuild Your Credit with Auto Loans
When a person has a low credit score rating, it can be very tough to get a credit card or a loan through regular means. Obtaining a car loan is typically much easier. This is because car dealerships have many lenders that they work with, and enough that they can find an interest rate that will please the customer, even though it may be a little higher. Car loan lenders also know that their loans are secured by vehicles as well.
If you consider how credit scores are calculated, car loans are a great way to re-establish your credit score. History of payments make up 35% of your credit score, and diversity another 10% – meaning that having a car loan helps your credit grow in two different categories!
How Car Loan Will Benefit You
Another way a car loan can help you rebuild your credit is that your spending will not get out of control. This is an “indirect” way, but it helps nonetheless. The fact of the matter is that you need credit in order to build your credit rating. Car loans are not a form of “revolving” credit and therefore can help you build your credit without making purchases that are detrimental to your financial health. With an auto loan, your payments are set at a certain amount each month, and you are not given access to any extra credit.
When you get an auto loan in Alhambra California it is crucial that you make your payments on time every single month. Do not be tempted to use the grace period. A grace period gives you more time to make your payment. For example, your payment date may be the 15th, with a grace period of the 20th. This means you can actually pay the payment on the 20th without receiving a late charge. You should instead make sure you make the payment on the 15th and do not use this grace period, as in the long run, it can affect your credit score.
Revolving vs. installment credit
Understanding the potential value of a car loan requires understanding how credit agencies view the two main types of credit: revolving and installment. Both play a role in your credit report.
Revolving credit, most often, refers to credit cards. It’s called revolving credit because monthly balances and payments rise and fall cyclically. Just because your credit card bill was $250 this month doesn’t mean it will be half that or twice that the next. Nor are you required to pay the exact, full balance. Minimum payment may be just $25, but you may also decide to pay the entire bill to avoid finance charges.
For credit agencies, this flexibility seems less applicable for securing financing for a car or home, which are installment loans. With an installment loan, you borrow a fixed amount, with set payments and no ability to borrow more or pay less each month. Because of this, installment loans are sometimes called “closed-end” accounts.
Credit Reporting Agencies
Also, installment loans usually are for larger amounts than revolving credit. This means you may be able to build your credit faster with an installment loan. A $25,000 car loan can establish your capacity to manage $25,000 worth of credit in just a year or two, compared to the slow-and-steady accumulation of credit through low-limit credit card. If home ownership is your ultimate credit goal, a car loan provides a parallel framework for a home loan.
Most credit reporting agencies reward borrowers for managing multiple types of credit, including a mix of revolving and installment credit. Additionally, credit agencies value active loans more than closed loans. Certainly, a successfully completed loan bodes well for your creditworthiness, but lenders are most interested in how risky it is to lend money to you right now. (For this same reason, older credit mistakes matter less than more recent ones.)
Making sure your car loan rebuilds your credit
Assess your financial situation
Using a car loan to rebuild your credit is a sound financial decision—if you can afford the car. If you can’t afford to take on more debt, getting a car loan will not be the answer. Focus instead on paying down existing debts until you can afford a car. Otherwise, you may end up making car payments only to fall behind on credit card debt. At best, that’s a zero-sum game for your financial and credit future.
If you are financially ready to take on a car loan (and perhaps a revolving line of credit, too), don’t open multiple new accounts at once. Three or more active credit accounts are enough for most credit agencies to see a diverse credit stream. Opening several accounts within a short time period can be a warning flag to credit agencies, which interpret those as actions of someone too eager, perhaps even reckless to expand their access to credit.
Choose the right vehicle
If your credit is only recently on the mend and money is still tight, it may not be time yet to splurge on your dream car. After all, steady payments on a used car get reported each month just as they do on a new car. (Be aware that some “Buy Here Pay Here” car sellers will not report your payments to credit bureaus—make sure your dealer reports payments so that you benefit from the car loan.)
One of the reasons that a car loan is more accessible for many with shaky credit is that dealerships benefit from selling cars, and they may be willing to take on slightly more risk than a traditional bank, which doesn’t benefit from a car moving off a dealer’s lot. Dealers also work with many lenders, increasing the chances of finding a lender who not only will approve your loan but will approve it with an interest rate you can afford.
As you rebuild your credit, remember that you’re unlikely to get the best-offered rates from a lender, simply because you represent higher risk. To help reduce the financial burden of higher interest rates, consider bringing a down payment to the table, which, while not essential, always helps with loan approval and your ability to pay back the loan.
Make your payments on time
Once you’ve secured your auto loan, nothing is more important than making on-time payments. Consistent, on-time payments are the best way to reinforce your creditworthiness and build your credit score. You can ensure on-time payments by setting up an automatic withdrawal through your checking account. You’ll save time and stress, and guarantee that you’ll never miss a payment.
Even within six months, a history of on-time auto loan payments can begin to show progress in your credit score. While paying off your car loan early may be an option—and seem like a good way to show responsibility each month you make an on-time payment is a valuable addition to your credit file.
If you pay off a 36-month loan in 8 months, it doesn’t provide as much history to credit bureaus. Of course, you will save on interest payments by paying off your loan early. It’s a balancing act based on your financial situation and the need to build credit with your auto loan.
If you decide to pay off your loan early, by any amount of time, make sure there is no prepayment penalty in your loan agreement. Also, remember that part of the evaluation of your credit is how much of your available credit you’re using. For example, if you pay off the remaining $7,000 on your car loan, you reduce your total debt by $7,000, but, by closing the loan, you also drop your total available credit by the original amount of the loan, which could quickly push your credit utilization rate higher.
Multiple factors impact a credit score. The number between 300 and 900 that is listed on your credit report represents your overall creditworthiness as a borrower. Your credit score is based on components like payment history, how much debt is owed, the total length of credit history, what kind of credit you have.
If you’re in an emergency situation and got bad credit, don’t worry. Car loans of America are here to help anyone going through financial emergencies. We work with bad credit scores and provide same day funding.
There’s no doubt that rebuilding credit takes hard work and practice, but consistent loan payments and ensuring that you have the right mix of credit will put you on the right track to a better credit score in the future.