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Auto loans, when managed responsibly, are likely to have a positive effect on your credit score.
When you have less than stellar credit, you spend a lot of time searching for ways to improve it. After all, a healthy credit score is essential to locking in lower interest rates on future loans and having access to a large variety of credit products.
In your pursuit of bettering your score, you may have come across the idea that taking out a new car loan could help you improve your credit score. If you are considering it, there are some things that you should know before you begin shopping around for the best loan.
Taking out an auto loan has the power to impact your credit score in a couple of beneficial ways. These include:
An auto loan can help you build your credit score, especially if you have limited lending experience. Since your credit mix makes up 10% of your score, adding a car loan could diversify the types of credit in your mix. This could be especially beneficial if you don’t have another installment loan in your lending history, like a student loan or mortgage.
Since one of the best indicators of future lending habits is someone’s lending history, credit bureaus (TransUnion®, Experian®, and Equifax®) reward those who make their payments on time with higher scores. Keeping your loan in good standing by consistently making on-time payments can help you build a positive repayment history or improve upon one that has taken a few hits.
How long it will take for your credit score to start seeing the positive effects of a well-managed car loan is dependent on two major factors:
Since each individual’s credit profile is unique, it is hard to say how long someone will need to wait to begin seeing improvements to their score. However, most lenders report new credit activity to the three major credit bureaus once a month, or at least every 45 days. Once the information is reported, it will likely begin to reflect on your score.
How much your score will change when you take out a new auto loan is unpredictable. Since everyone’s credit history is unique to them, the effects of a new loan will be too. In fact, some might not see any change in their credit score whatsoever.
That said, borrowers who are looking to see major changes in their scores should work hard to maintain a positive loan status.
Auto loans have the potential to negatively impact your score, especially if you do not use them responsibly. Here are a few of the major risks:
When applying for a loan, auto lenders will, almost always, perform a credit check to check your creditworthiness. Bill Ryze, ChFC® and a board advisor at Fiona, says that this essential part of the application review process has the potential to “lower your score by a few points, usually less than ten.”
How do you avoid collecting too many hard inquiries? Start by taking advantage of the 45-day rate shopping window. During this period, which begins once your first hard inquiry is submitted, you can shop around for the best loan rates, and all of the required hard inquiries for similar loan products will be reported as one hard inquiry on your credit report.
Have you ever heard a friend or family member complain because their credit score dropped after they paid off their car? Unfortunately, this is a risk that comes with taking on a car loan, especially if you pay it off too quickly.
Usually, a positive open account performs better than a closed one, based on the credit score formula.
I asked Ryze to explain to me why some borrowers might see their score drop, he said: “Usually, a positive open account performs better than a closed one, based on the credit score formula. Your payment history greatly influences your credit score. So, by paying off your auto loan, you reduce the length of your credit history and the positive performing status of your active loan, which could affect your credit score.”
Credit bureaus (and the lenders that trust them) like to see that you are capable of managing multiple types of lending accounts long-term. This is why the age of your lines of credit matters!
When you take out a new loan, although you are raising the amount of credit available to you, you are lessening the average age of your credit lines and therefore the length of credit history — which accounts for 15% of your credit score.
To avoid reducing your average credit age — and lowering your credit score — only take out an auto loan if you plan on keeping the vehicle you purchase long-term. If not, leasing your vehicle may be better for your finances, especially if you already have a good credit score.
Not making car payments on time is one of the easiest ways to sabotage your credit score, especially if you have a history of missed or late payments. To combat this, never take on a loan that you can not afford to pay back. If you aren’t able to pay back your loan, your car could be repossessed, causing further issues on top of an already poor credit score.
If you already have an auto loan, but it’s in less than stellar standing, you may still be able to improve your score or at least lessen the damage to it. To do so, consider doing the following:
If you are unable to keep up with your auto loan, a call to your lender should be one of your first steps. Your lender may have options that can help prevent you from missing loan payments or defaulting on your loan altogether. You’ll never know unless you ask.
Depending on your account standing and lender, you may be presented with a couple of options to help you get your loan back on track, including:
If you are having trouble keeping up with your auto loan payments, you may want to consider refinancing your auto loan.
Although refinancing comes with a hard credit pull, which could have a negative impact on your score temporarily, refinancing might lower your monthly payments and give you a better rate. You might find that with more affordable payments, it’s easier to improve your repayment history.
When you have bad credit, it can be tempting to say “sign me up!” to every offer that gives you the chance to improve it. However, if you do so, you may find yourself in even deeper water.
This is because bad credit borrowers often find themselves with lower loan limits, higher interest rates, and overall less impressive loan options. Some may even find themselves unable to take out an auto loan if their low credit score is disqualifying.
With an auto loan, this could mean that you end up with higher monthly payments than you bargained for and you end up paying more over the life of the loan. If you don’t address the financial habits that lowered your score, this could end poorly for your credit profile.
If you have more than a couple of points to make up, you may want to consider other ways to build credit before you take out an auto loan. For instance, secured credit cards or debt consolidation loans.
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