Credit: self.inc
Taking out a loan to buy a car could help your credit, but there are some things to consider – most important is whether you can make the monthly payments on time and in full. Read on to learn more.
If you’re working on building your credit and need a new car, you may wonder whether buying a car will help your credit.
Buying a car can help your credit score — as long as you handle your loan well. But don’t be surprised to see a drop in your credit score immediately after taking out an auto loan. In most cases, the effect will be short-lived.
Keep reading to learn more about how buying a car affects your credit, so you know what to expect.
Should I buy a car with bad credit?
When you buy a car, you have several options for paying for it. Of course, if you have the funds available, you can pay cash for a new or used vehicle. Paying cash won’t impact your credit score because the only way buying a car can directly affect your credit is if the auto lender reports to at least one of the credit bureaus.
However, paying cash for a car can indirectly affect your credit if it affects your ability to make payments on other loans or lines of credit. For example, if you miss a credit card payment because you used all your cash to buy and register your new car, that late monthly payment will negatively impact your credit score or credit rating.
Few people actually have enough cash lying around to pay cash for a car. That’s why 85% of all new car purchases and 53% of used car purchases in the U.S. are financed, according to a report from the U.S. Public Interest Research Group.
When you finance a car purchase, the dealership, bank, or financial institution providing the loan will run your credit. If you have bad credit, you could have trouble getting approved for an auto loan or only qualify for a higher interest rate.
If you don’t need a car right now, it’s better to delay applying for a car loan until you can improve your credit score. Remember that defaulting on a car loan will have a serious impact on your credit score. However, if you need a car for reliable transportation to work or other reasons, shop around for the best deal you can find. Your poor credit might limit your options, but some lenders still offer lower rates than others.
Once you get the loan, it’s crucial to make all your payments on time. Lenders typically report payments made more than 30-days late to the credit bureaus, meaning the late monthly payment will show up on your credit report and negatively impact your credit score. And if you fall seriously behind on your payments, your loan could go into default, at which point your lender has the right to repossess the car. A repossession can cause a serious drop in your credit score or credit rating, and it will stay on your credit report for seven years.
How much will my credit score drop if I buy a car?
It’s impossible to predict exactly how buying a car will affect your credit score because it depends on your unique credit profile. However, understanding the factors that go into calculating your credit score can help you get an idea of what to expect.
When FICO calculates your credit scores, it considers the following five factors:
- Payment history accounts for 35% of your credit score. Paying your credit accounts and loans on time is the most important factor in the FICO credit scoring model.
- Amounts owed accounts for 30% of your credit score. Using a large percentage of your available credit signals to the credit bureau that you’re having financial troubles and may default on your loan.
- Length of credit history accounts for 15% of your credit score. A long history of using credit responsibly looks better than having only used credit for a short time.
- New credit accounts for 10% of your credit score. Opening several new accounts in a short period signals to credit bureaus that you may be experiencing financial troubles.
- Credit mix accounts for 10% of your credit score. A combination of credit cards, installment loan, and other types of credit is preferable to using only one type.
Taking these factors into account, buying a car can impact your credit in a few ways.
First, when you shop around for the best interest rate, potential lenders will perform a hard inquiry on your credit report. A single hard inquiry typically drops your score by a few points. Multiple hard inquiries for the same type of loan within a short timeframe (14 to 45 days according to FICO) are treated as one inquiry — the credit scoring model won’t penalize you for shopping around for the best rate.
Next, taking out a new loan will lower your accounts’ average age, which may cause another slight dip in your score. If you’ve had several different credit accounts for many years, the change should be minimal. However, if you only have one or two accounts that haven’t been open long, this could have a bigger impact.
How long until my credit score improves after buying a car?
Fortunately, the above hits to your credit score are only temporary. In the long term, buying a car can improve your credit score in two ways.
First, making your auto loan payments on time every month will add to your positive payment history, which has the biggest impact on your FICO score. In addition, adding a new loan to your credit profile can improve your credit mix. Credit scoring models like to work with borrowers who’ve shown they can manage different types of credit responsibly. If you previously only used revolving accounts, like credit cards, adding an installment loan could positively impact your credit score.
How can I make sure my credit is ready to buy a car?
Before financing a car purchase, doing what you can to get your credit in good shape can help you qualify for a lower rate and have an easier time qualifying for financing. These tips can help.
- Check your credit report and credit score. This will show you where you stand and give you a chance to ensure that the information included in your credit report is accurate. If you find any errors, contact the appropriate credit bureau to dispute the error.
- Pay your bills on time. Payment history is the single most important factor in calculating your credit score, so be sure to pay all your bills on time. Consider setting up an automatic car payment or adding reminders to your calendar to help you stay on top of due dates.
- Pay down your credit card debt. Paying down credit card debt could improve your credit utilization ratio and your debt-to-income ratio.
- Set an interest rate goal. Many dealerships advertise zero-interest car loans, but these deals are usually only available on new cars (not used cars), may only apply to certain models, and are reserved for customers with strong credit. For a better idea of the annual percentage rate (APR) you might qualify for, try FICO’s Loan Savings Calculator, which shows how your credit score impacts the rate you’ll pay on a loan. If your credit score is just a few digits away from qualifying for a better rate, you may want to set a goal to improve your credit score to qualify for the lower rate.
What’s the fastest way to get my credit ready to buy a car?
The shortest path to improving your credit score in advance of buying a car really depends on your credit history and what types of credit you currently have. However, here are a few general steps that can improve almost anyone’s credit score.