Looking to help your credit and in the market for a car? You can actually build your credit with a car loan. Find out how!
Credit scores are pretty important when making major purchases. They can affect if you can get a loan, what rates you get, approval for a credit card, being accepted for a rental, and plenty of other financial aspects in all of our lives. So, if your credit score isn’t looking too hot, does financing a car build credit? In short, it can if you do it right. I know all of the Dave Ramsey fans are screaming at me right now, but there are some positives to bringing on this kind of debt. Here’s a quick look at how a car loan affects your credit and how you can potentially come out on top with a better credit score.
Before we start with the positive sides of things, we have to explain some of the initial negatives that come along with it. First is the initial hard inquiry when applying for a car loan. This hard inquiry to your credit report happens when you submit your loan application and can have an immediate impact on your credit score. Typically, this impact is a loss of anywhere from 5 to 15 points depending on the loan amount. An important thing to know once you undergo this hard inquiry is that you can gather multiple loan quotes from different sources usually within the next 30 days with no additional effect on your credit score. Getting quotes from all these different loan services can help you find the best rate for your car purchase.
Once you’ve established which loan servicer you’re going through for your car loan, you can go out and get the car. When the car loan is processed, this will be added to your credit report as a new loan line. This new car loan will affect your credit score once again as it presents itself as a new loan on your report, it will raise the overall debt you possess, it will lower the average age of your different credit accounts, and change your utilization ratio.
That credit age piece affects your score more depending on how long you’ve held different credit accounts. If you have accounts that are multiple years old, the impact will be marginal. If your credit history is relatively new, then the average age change will be more significant. As for the utilization ratio, this is a calculation of how much of your available credit you are using. It’s best for utilization to remain lower than 30% of your total available credit, but this new car loan can skew utilization higher since it is considered at 100% utilization to start. Overall, the new car loan may drop your credit score anywhere from 30 to even 75 points depending on personal situation, length of loan, and loan amount.
Now that we’ve pointed out a majority of the negative impacts that occur, we can focus on the positive aspects that come from a new car loan on your credit report. To start, if you’ve never had an installment loan before (such as a previous car loan or mortgage), this car loan can help you gain a better credit mix. Having a good credit mix can help show that you’re capable of handling different kinds of debts rather than just revolving credit card debt.
The next point in gaining positive credit history with a car loan lands squarely with you. Making payments on time every month will gradually help your credit score and prove that you can handle this newly acquired debt. Establishing a strong payment history is key in utilizing a car loan to help improve your credit score in the long run. Making these payments towards the car loan will also help lower your credit utilization every month as you approach the payoff balance. Having a longer-term loan here can also help in raising the average age of credit among your accounts as time goes on.
Just keeping the car loan in check isn’t going to solve everything with your credit. It’s important that you keep your other different credit lines in check while paying this car loan too. Allowing a credit card to hit its limit, missing payments, or applying for other forms of credit can all negatively impact your credit score. Your credit history is a gathering of different financial pieces, so you must remain vigilant on all fronts to really see an increase on your score.
If you’re keeping up on all your payments and not opening any new forms of credit, you can see your credit score begin to bounce back to its initial value in a number of months. This all depends on your prior credit history. A longer credit history can mean it’s possible to bounce back in as little as 3 months, while a shorter credit history can take anywhere from about 6 to 12 months to get back to that initial score. Once you see this rebound of your score, that’s when the car loan starts to help increase your credit score gradually.
Now, when you get to the end of your car loan and eventually pay it off, you’ll see another decrease to your credit score. You’d think it’d be a positive thing to show on your credit history that you paid off a loan, but it actually is removing your active installment loan once this happens. This credit score drop should gradually rebound in a similar fashion to how it did in the months following your new car loan.
In the end, if you have kept up on all of your payments for the car loan and any other forms of credit you have, your credit score should reflect a net positive increase in the long term.
After paying off your car loan and gaining a higher credit score, you can now access new credit lines with potentially better rates and for higher amounts. Now you can apply for a mortgage to get a garage for that paid off car to park in, or perhaps you’re looking to trade in that used ride and are on the lookout for a new car. Whatever the scenario, you’ll have a better credit score to work with and are ready to keep that score rising.
Buying a car with a car loan may help you raise your credit score if done right, but make sure you know how to take care of that car you’re paying for too. Check out our other articles that explain car insurance, help you properly wash your car, and answer any maintenance questions you may have.