Financing a car can help build your credit score if you make on-time payments. But it can also hurt it if you’re not careful. In this guide, we’ll show you some ways financing a car can help raise and lower your credit score, so you can avoid costly mistakes.
Why is building credit so important?
Credit is king in the U.S. You need it for everything — from getting a good rate on loans to even saving money on car insurance. Good credit is how you prove to lenders you’re reliable and trustworthy. It’s how you show them you’re good at paying back what you borrow. A good credit score leads to lower interest rates on loans, which leads to more money in your pocket over time. On the flip side, a bad credit score can make it harder to get approved for loans and lead to higher interest rates and fees. Read more: Understand the credit requirements for auto loans, get a better rate
How does financing a car help your credit score?
Now that you know why you should have a good credit score, let’s talk about how financing a car can help you get there. When you finance a car, you’re essentially taking out a loan to pay for the vehicle. This helps boost your credit score in two ways:
1. Strengthens your payment history
Payment history is EVERYTHING in the credit world (it makes up 35% of your total score). Pay even one bill late and it can do some damage. But if you make your payments on time and in full each month, the credit gods will shine down on you from the heavens. And you’ll be rewarded with a credit score that gets bigger and bigger over time.
2. Diversifies your credit mix
Having an installment loan (like a car loan) helps diversify your “credit mix,” which, in turn, can also help boost your score. What is a credit mix, exactly? It’s just a fancy way of saying you have different types of credit accounts. So, rather than having all credit cards or all student loans, you’ve got some variety. And remember those credit gods from earlier? They believe variety is the cherry on top of a good credit score.
How does financing a car hurt your credit score?
While financing a car can help improve your credit score, it can also hurt it. Here are a few examples:
1. Hard inquiries temporarily lower your score
Every time you apply for a car loan, the lender does a hard inquiry on your credit report to see which rates you qualify for. These hard inquiries can temporarily knock points off your score. And they can stick around on your credit report for up to two years. The good news is, that if you do multiple hard inquiries in a short time, they usually only count as one inquiry. For example, FICO counts any hard inquiries made within 30 days as one inquiry.
2. Missed payments stick around for the long haul
If you miss payments or default on your auto loan, this can also damage your credit score. So, when financing a car, make sure you can afford the monthly payments. Otherwise, you could end up doing more harm than good to your credit score. Read more: The 5 biggest mistakes people make when buying a car
6 questions to ask before financing a car
Financing a car is a really big deal. Before you do it, make sure it’s the right financial move for you. If you’re feeling stuck, here are some questions to ask yourself (and your dealer):
- How much can I afford to spend on a car?
- What kind of interest rate will I qualify for?
- How long do I want the loan to be?
- Will I have a downpayment?
- What fees will get tacked onto the sticker price of the vehicle?
- What else do I need to know about the financing process?
Answering these questions can help you avoid making mistakes that could hurt your credit score. For example, a 60-month loan may have a lower interest rate, but if the payments are too high for your budget, you could miss a payment or default on the loan entirely. In this case, you may be better off financing a cheaper vehicle or going with a 72-month loan. Read more: How to finance a car the smart way
Tips for boosting your credit score over time
There is no quick and easy way to improve your credit score. However, with time and persistence, you can watch it tick up with these tips:
- Make all of your payments on time, including your car payment, credit cards, mortgage, and so on.
- Try to diversify your credit mix by having a mix of different types of loans, such as a car loan, a student loan, and a credit card.
- Keep balances low on your credit cards. Ideally, you should use less than 30% of your credit limit.
- Check your credit report regularly for errors and dispute any inaccuracies you find.
Read more: How to build credit the right way
What to do if you’re struggling to make your car payments
If you’ve already financed a vehicle and are finding it difficult to make payments, you have a few options to consider:
Refinance your loan
If you have good credit, you may be able to qualify for a lower interest rate by refinancing your loan. This could lower your monthly payments and make it easier to afford your car. Read more: How to refinance your car loan in 7 steps
Trade in your car
If you’re upside down on your loan (meaning you owe more than the car is worth), you may be able to trade it in for a new one and roll the negative equity over into a new loan. Read more: Car dealer secrets: how to be confident you’re getting a fair deal on your trade-in
Sell your car
You could also try selling your car and using the money to pay off the loan. This could be difficult if you’re upside down on the loan, and it may not work if you don’t have any other means of transportation. Still, it could be worth a try. Read more: The 5 best ways to sell your car (in terms of ease, value, and convenience)
Defer your payments
Some lenders may offer programs that allow you to defer your payments for a month or two. This can help if you’re facing a temporary financial setback. However, interest will continue to accrue during this time, so you could end up paying more in the long run.
Get help from a credit counseling agency
If you’re struggling to make ends meet, you may want to consider getting help from a credit counseling agency. These agencies can work with you to create a budget and come up with a plan to get out of debt. No matter what option you choose, be honest and upfront with your lender. They may be willing to work with you to find a solution that works for you both.
Financing a car can help or hurt your credit score depending on how you manage the loan. If you’re thinking about financing a car, make sure you understand the process and can afford the payments. And if you’re struggling to make your car payments, there are options available to help you get back on track. Featured image: Standret/Shutterstock.com