Applying for an auto loan could temporarily ding your score, but paying on time, every time will more than offset that.
As you roll out of the car dealer’s parking lot in your brand new ride, you’re probably not thinking much about the auto loan you just signed or how it might affect your credit.
But if you’re not careful, a few small mistakes may make it difficult for you to secure other lines of credit.
How Car Loans Affect Credit Score
Getting a new car loan has two predictable effects on your credit:
- It adds a hard inquiry to your credit report, which might temporarily shave a few points off your score. Refinancing a car has a similar effect on your credit.
- It adds to your credit history, which has a positive impact, assuming you pay on time, every time.
If you pay as agreed, the credit score points you temporarily lose when you applied should be more than offset by the ones you gain from a history of on-time payments.
What to Know About Car Loan Shopping
Your application for auto financing will show up in one more place: credit inquiries. Inquiries made when you apply for credit can cost you points on your credit score. But if you group applications for car financing close together, they should count as just one.
While you’re shopping for the lowest auto loan rates, you may allow multiple lenders to run credit checks and end up with several hard inquiries listed on your credit report. That’s OK.
If you’re shopping for an auto loan, multiple hard inquiries within a 30-day period will generally only count as one when your FICO score is calculated.
Generally speaking, if you’re shopping for an auto loan within a 30-day period, all those hard inquiries that are listed on your credit report will only count as one when your FICO score is calculated. The Vantage Score has a 14-day rolling window for shopping. Play it safe and keep your search brief so that your credit score doesn’t take an unnecessary hit.
Adding to Your Credit Profile
The main reason a car loan is a good way to build and improve your credit score is because, as you make payments on time, you begin to build a positive payment history. Payment history makes up 35 percent of your FICO credit score, which is the score most commonly used by lenders.
Auto financing also adds to your credit mix and new credit, which make up a combined 20 percent of your credit score. So, by getting a car loan and keeping up with your payments, you’re impacting more than half of the things that influence your overall FICO score.
Building Credit with an Auto Loan – The Pros
If you’re thinking about using an auto loan to help you rebuild your credit score, here are some of the benefits of doing so.
Installment loans can help build your credit score – Your credit mix is one of the primary methods by which your credit score is determined. Ideally, you want a mix of revolving debt (Credit cards) and installment loans (student loans, mortgages, personal loans, auto loans).
If you only have a credit card, you may not be building your credit score as quickly as you could if you also had an installment loan. However, your score will always continue to increase as long as you pay off all of your debts on time, regardless of the different mix of credit you have.
You can refinance once you get a better credit score – If you have a bad credit score, you may have to get a car loan at a 10% or higher APR, which is not ideal. However, even repaying your loan on time for 6 months can boost your credit score significantly.
Once you have better credit, you can refinance your loan at a different lender. When you get a lower APR, your monthly payment will decrease. You will also pay less total interest on the car, saving you money in the long run, and making your finances more manageable.
Auto loans have a bigger effect on mortgage eligibility – Auto loans, like mortgages, are installment loans. That means that, when you eventually apply for a mortgage to buy a home, lenders will want to see that you are able to repay installment loans in a timely fashion. While credit cards can boost your score quite a bit, they do not have as much of an effect on your credit score when it comes to purchasing a home.
Building Credit with an Auto Loan – The Cons
Here are a few drawbacks to taking out an auto loan in order to build your credit.
Your new car could get repossessed – If you take out an auto loan that’s too much to pay back, and you fail to make payments, your new car could get repossessed – which will devastate your credit score. Make sure that you’re ready to take on the responsibility of an auto loan – especially if you are considering trading in a car that’s already “bought and paid for”. Otherwise, you could end up in a worse position in the long run.
Bad credit could mean unreasonable interest rates – If you have very bad credit – under a 600 FICO score – it’s probably not a good idea to get an auto loan. You could pay a 15-25% APR – which means you’ll be paying thousands of dollars in interest over a 5-year auto loan.
It’s a good idea to try to rebuild your credit somewhat before applying for an auto loan in order to avoid this.
Ties up money you could use to pay other debts – If you have outstanding credit card debt, and are only paying minimum payments on it, you should not be considering an auto loan. Your APR on your credit cards will usually vary from 15-24% – so paying them off first is the best way to rebuild your credit score and save money.
If you really need a reliable car to get to work, this advice may not apply – but it’s still a good idea to pay down as much other high-interest debt as you can before you get an auto loan.
Is There a Faster Way to Improve My Credit?
The fastest way to improve your credit is to be a responsible consumer. Paying all your bills – not just your car payment – on time and in full each month can help improve a bad credit score. Nothing can turn your credit around overnight, but using credit responsibly and building diversity in your credit profile will certainly help.
In addition to making your payments on time, here are a few tips to help your credit improve sooner:
- Don’t close your credit cards. In order to have a solid credit profile, you need a solid credit history. So, keeping a few credit cards around that you’ve had the longest will help…
As long as they’re not maxed out. Lenders like consumers to keep the amount of their available credit use to 30 percent or less. This shows that you’re both using your credit and paying your bills.
- Keep a mix of both installment credit, such as car loans and mortgages, and revolving credit, such as credit cards…
But don’t apply for too much credit all at once. It could be a red flag to lenders if you’re applying for everything in sight, instead of just the credit you need.
Use these tips to your advantage, and remember to monitor your credit reports and score as well. Accuracy is important. Removing incorrect information from your credit reports can also raise your credit score.
Your credit score is based on 5 factors
- Payment History
Do you make on-time payments? Have you ever been late in making a payment? If so, how late — 30 days? 60 days? 90 days?
This is the single most critical factor. It counts for 35 percent of your total credit score.
2: Utilization Ratio
How large is your outstanding balance, relative to your total credit limit?
Outstanding Balance — how much you owe
Total Credit Limit — the maximum you’re allowed to borrow
Ideally, you should use 20 percent or less of your total credit limit. In other words, if you have a $1,000 credit limit, you should borrow no more than $200 per month.
Here’s the kicker: This rule applies even if you pay the balance in full each month.
If you have a $1,000 credit limit and you rack up a $700 balance, you’ll be seen as someone who uses 70 percent of their total credit limit — even if you pay-in-full at the end of the month.
Best practices: Ask for a higher credit limit. Charge smaller amounts. Or pay off your cards weekly, instead of monthly.
Your utilization ratio counts for 30 percent of your total score.
3: Length of Credit History
How old are your accounts?
The older, the better, which is why you shouldn’t close old credit cards, even if you’re not using them. Getting a new credit account (e.g. getting a car loan) could hurt your score by reducing the “average age of your accounts.”
Best practices: Keep your oldest accounts alive. If you don’t use that credit card anymore (e.g. perhaps you get better rewards from a different card), keep the account active by making a small monthly purchase, like your Netflix subscription, on your old credit card. Automatically pay the bill, so you’ll never miss a payment.
4: New Credit
No one likes a desperate fellow.
The more you apply for credit — especially in a short amount of time — the more your score drops.
Credit agencies interpret this as a sign that you’re desperate for funds. (Why else would you be asking for credit?)
And like in dating, desperation is a turn-off.
Applying for a car loan can hurt you if you’re getting a mortgage soon.
Best practices: Avoid applying for credit (e.g. car loans, credit cards) within 6-12 months of applying for a mortgage.
This affects 10 percent of your score.
5: Types of Credit in Use
Okay, here’s where we can make the “get-a-car-loan” argument.
There are two types of credit:
Installment credit — you make fixed, regular monthly payments. Examples: Car loans, Mortgages, Student Loans.
Revolving credit — you have an open line of credit, with fluctuating balances and payments. Examples: Credit cards.
Credit-scoring agencies view installment credit more favorably than revolving credit. This is where the “getting a car loan improves your credit score” myth comes from.
But the type of credit you use (installment vs. revolving) counts for only 10 percent of your total credit score. That’s not significant enough to justify getting a car loan, especially you consider that your credit score will suffer when you apply for a new line of credit and reduce your average account age.
All in all, getting a car loan and making your payments on time is a great way to improve your credit. Plus, you don’t have to worry about credit that’s seen better days standing in your way if you use a reputable lender! In order to get the financing you need, you need a lender that can work with challenging credit situations. And these aren’t lenders you can just walk off the street and get a direct loan from.