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.
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.
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:
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.
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.
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.
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.
Buying a car could improve your credit score in the long run, but it's not necessarily the best way to go about improving your score. Instead, take the steps above to ensure your credit report and credit score are in good shape before heading to the dealership. That way, you'll qualify for a lower interest rate and better loan terms, which could make buying a car more affordable overall.
Michelle L. Black is a leading credit expert with over 17 years of experience in the credit industry. She’s an expert on credit reporting, credit scoring, identity theft, budgeting and debt eradication. See Michelle on Linkedin and Twitter.
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