Taking out a car loan can be a bit of a tightrope act: depending on your financial stability, the loan can make or break your credit report.
Paying on time is an easy way to elevate your score, but late payments can quickly sneak up on you.
This means the most important consideration for a car loan (or any loan for that matter) is how to borrow within your means.
Following that golden rule will determine the lasting effects a car loan will have on your credit score — which can range from positive to detrimental.
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How a Car Loan Can Improve Your Credit Score
One of the best overall ways to improve a credit score is to seek a diversity of revolving credit and include investments like credit cards and installment loans.
Car loans are a great starting point for many people looking to establish a history of payment through installment loans. This loan is much less of a financial investment than other borrowing options, like a mortgage, but still lets individuals build towards a higher credit score.
If you’re seeking a car loan and already have a high credit score, you’re ahead of the curve. Those with an established credit report can secure a car loan for a lower interest rate, which can save you thousands over the lifetime of the loan.
It’s a good idea to build up your credit before biting off a costly car loan since a lower interest rate makes monthly payments much more bearable.
Anytime you take out a loan your credit will be affected — whether it has a positive impact or not comes down to your spending habits.
You may take out a loan with good intentions, but those intentions don’t always pay the bills, and your credit score can go south fast if loan payments start coming in late.
There are some key strategies to consider in order to preserve your credit score if it’s no longer in the budget.
Will a car loan negatively affect my credit score?
Naturally, there is another side to the car loan coin. The caveat to the fruitfulness of a car loan is, as with any type of lending, borrowing outside of your means will negatively affect your credit score.
Even one or two late payments can imprint you with a high-risk reputation. While it might not seem like a big deal at the time, late payments compound evidence against you and can lead to a low score — negatively marking you for borrowing and interest rates down the line.
Of course, unforeseeable circumstances can sometimes get in the way of good intentions, but there is a way to be proactive if your finances take a wrong turn. If you’re able to anticipate a late payment, it’s best to get in front of it as soon as possible.
If you expect an isolated late payment is on the horizon, call your lender and explain the situation. Together you can figure out a plan to keep the credit score on the right track and prevent the occasional hiccup from tanking your credit score.
Know When to Refinance
A late payment every once in awhile can easily turn into a habitual issue. Maybe life got in the way of grand finance plans or you bit off more than you can chew while standing in the new car lot — either way, you’re stuck with a loan you can’t afford.
Worst of all, every late payment is incrementally affecting your credit score. If you’re stuck in this common situation it might be time to refinance your car loan.
There are several practical reasons to refinance an auto loan, but two major ones include:
1. Your credit score has improved
A credit score can go through a lot of changes over a couple of years. If you bought a car with a low (or nonexistent) score, and it has since improved, you can garner a lower interest rate by refinancing.
Even if it is only a couple percentage points lower, a minor interest rate adjustment will still save you a lot of money over time. If your credit report is teetering, and you would like to jumpstart the process of rebuilding your score, partnering with a credit repair company can help you get back on track.
2. Personal finance trouble
In the event of a financial setback, refinancing will reduce monthly payments. Granted, this method will make the loan drag on longer, but at least this way you can afford payments and preserve your credit score.
Refinancing is a great way to hit the restart button on a loan. Whether your finances have improved or deteriorated, refinancing caters to both poles of the credit spectrum.
Keep in mind, there are a few circumstances when refinancing isn’t an option. For example, in the event the value of a car is less than the initial loan refinancing is not an option.
If you are “upside down” on a car loan, you might need to reevaluate your assets. Many people caught in this situation will sell their cars to help pay off the loan, and handle the remaining negative equity with an additional loan.
This cycle of borrowing should be avoided at all costs to preserve your credit score — not to mention bank account and sanity — so if the cost of a loan is approaching the value of the car it might be time to jump ship. You can check the value of a vehicle through online resources like Kelley Blue Book.
How to Shop for a Car Loan
When you’re borrowing a significant amount of money you will want to find the lowest interest rate possible. During this process, you will likely allow several lenders to run credit checks.
Under normal circumstances, multiple credit checks will deduct points from your credit score so excessive hard inquiries should be avoided. However, when it comes to auto loans there is an exception.
If all credit checks are done within a 30-day period all hard inquiries listed on your credit report will be treated as one when your FICO score is calculated.
You will have to commit to one hard inquiry, which will shave about 5 points off your FICO score, but that’s a small price to pay to find a low interest rate loan.
An excessive amount of credit checks can slowly chip away at your credit score, so make sure to keep your loan search brief in order to benefit from the 30-day credit check bundling.
Buying a car is a big investment and can have a major impact on your credit. Depending on how the loan is handled, the lasting effect can vary.
Car loans can be a great way to diversify your credit report and begin building your score through regular installment loan payments but that ideal result comes along with several considerations.
If you are honest with yourself about borrowing potential then monthly payments should be a breeze. You will be able to knock out payments without issue and gradually build your credit score. If financial hardship gets in the way of lofty goals then it might be time to reevaluate.
Staying in touch with your lender on a case-by-case basis can help mitigate issues and prevent long-term issues. Worst case scenario, if it seems like late payments might become the norm, it might be time to start from square one and refinance.
No matter what the outcome might be, be sure to always borrow within your means and remember how the car loan will gradually affect your credit score.