Taking out a new car loan can be a bit of a tightrope act. Depending on your financial stability, the loan can make or break your credit.
Making on-time payments is an easy way to raise your credit score. However, by making even one late payment, it could have the opposite effect.
This is why borrowing within your means is one of the most important consideration when taking out a car loan. You will be able to determine how a car loan will affect your credit score based on this golden rule.
How a Car Loan Can Improve Your Credit Score
One way to improve your credit score is by creating a credit mix of revolving credit accounts and installment loans. Revolving accounts include credit cards and home equity lines of credit (HELOCs). While installment loans include loans like student loans, mortgages, and car loans.
Car loans are a great starting point for many people looking to establish credit history through installment loans. Auto loans are much more affordable than other borrowing options, such as mortgages. They also don’t affect your credit utilization as credit cards do. However, it still helps you build credit.
How Applying for an Auto Loan Will Impact Your Credit Score
If you’re seeking a car loan and already have a good credit score, you’re ahead of the curve. Those with established credit can secure a car loan with lower interest rates. And that can save you thousands over the lifetime of the loan. It’s a good idea to build up your credit history so that you can lower your car payments.
Anytime you take out a loan, it will affect your credit history. Whether it has a positive impact or not comes down to your spending habits. You may take out a loan with good intentions, but if you don’t make your monthly payment on time, it can really damage your credit scores.
There are some key strategies to consider to increase your credit score if it’s no longer in the budget.
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Will a car loan negatively affect my credit score?
As with any other type of loan, borrowing outside your means will negatively impact 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, they can lead to a low credit score. They can negatively impact your chances of borrowing and impact your interest rates down the line.
Of course, unforeseeable circumstances happen, 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.
Call your lender and explain the situation. Together, you can figure out a plan for maintaining your credit score and preventing hiccups from ruining it.
Will an auto impact my credit utilization?
Your credit utilization will not be directly impacted by an auto loan, as it is a type of installment loan. Only revolving credit accounts, like credit cards, impact your credit utilization.
The only way an auto loan can affect your credit utilization is if the loan increases your total amount of debt. If you take out a loan for a car that is more expensive than what you can afford, and it increases your overall debt load, then your credit utilization ratio will go up.
In contrast, if you take out a loan for a more affordable car and it doesn’t increase your overall debt load, then your credit utilization ratio will remain the same.
Know When to Refinance
Every late payment is incrementally impacting your payment history and 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 your credit score has improved since you bought the car, refinancing can help you get a lower interest rate.
Even if it is only a couple of percentage points lower, a minor interest rate adjustment will still save you a lot of money over time. If your credit report is teetering you may want to consider partnering with a credit repair company. They can help you get back on track and rebuild your credit score by disputing negative items on your credit report. They deal with your creditors and the major credit bureaus for you.
2. Personal Finance Trouble
In the event of a financial setback, refinancing will reduce monthly auto loan payments. Granted, this method will make the auto loan drag on longer. However, at least this way, you can afford payments and preserve your credit scores.
Refinancing is a great way to hit the restart button on an auto 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, if the value of a car is less than the initial auto 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. Then, they handle the remaining negative equity with an additional loan.
This cycle of borrowing should be avoided at all costs to preserve your credit score. So, if the cost of an auto 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 auto lenders to run credit checks.
Multiple credit checks will deduct points from your credit score under normal circumstances, so excessive hard inquiries should be avoided. However, when it comes to shopping for an auto loan, there is an exception.
Multiple Inquiries for the Same Type of Loan
If all credit checks are done within a 30-day period, the 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 scores. So, make sure to keep your auto loan search brief 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. You can begin building your credit scores with regular installment loan payments.
If you are honest with yourself about borrowing potential then monthly payments should be a breeze. By making on-time payments without issue, you will be able to gradually build your credit scores. 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. Regardless of the outcome, always borrow within your means and keep in mind how a car loan will slowly affect your credit score.