We all know there’s good and bad debt. Mortgages are sometimes referred to as “good” debt, while credit cards tend to be referred to as “bad” debt because of the high interest rates and large amount of fees attached.
But where do car loans come in?
Some people argue that since auto loans are backed by the value of the car and the interest rate is very low, it makes good financial cents (ha!) to buy them. Others say it’s better to buy a used vehicle.
Whichever opinion you side with, car loans are still considered consumer debt, but they’re in a category all their own. Here’s how car loans affect your credit score:
A New Mix of Credit on Your Report
Your overall credit score is made up of several different sections, and about 10% of your credit score reflects the type of credit you’ve utilized. For instance, credit cards represent one type of credit usage, car loans make up another portion and mortgages round out the bunch.
The overall goal is to mix up your credit with different types of loans, so you can increase your credit history and subsequently your credit score.
Having a car loan on your report shows a new mix of credit, and can help improve your overall credit report. Additionally, if you make payments om time it shows you’re less of a risk to loan officers and banks.
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A Good Measurement of Responsible Credit Usage
For some people, the progression of using credit to build a solid history for making large purchases such as buying a home begins with an auto loan. Applying — and getting approved — for a credit card is a very simple process, but getting approved for a car loan is a bit more difficult. If your credit report shows evidence of on-time payments on your car loan, it will help increase your credit score.
Having a good history and no late payments shows you’re a responsible borrower and someone who could pay a future mortgage fairly easy. (Even one late payment can hurt your score)
If you have any problem paying your auto loan and your car gets repossessed, that will be an indication to banks that you will struggle to make larger payments for something like a mortgage, and it will make your credit score go down.
A car loan is often a step in the process for proving your credit worthiness, so make sure you’re ready to take on that responsibility before you make the leap.
Little Room for Underwater Car Loans
Much like the housing market, the automotive industry has been all over the place, and many people have been caught with cars that are worth less than the amount they owe on the loan.
Having a car loan that’s underwater, can reflect badly on your credit report. So it’s important to understand that taking out a car loan is risky if there’s any chance you won’t be able to pay, even in the event of an accident or other emergency.
I have some personal experience with this: I was almost forced into this situation when I got into a bad car accident that totalled 3 cars. A lady ran a stop sign and hit a car that hit me. And to make matters worse, she didn’t have insurance!
In situations like these, if you don’t have an emergency fund, or good car insurance coverage, you could be forced into a bad situation financially — and your credit report won’t easily forgive it.
Refinancing Your Car Loan is a Hard Inquiry
When you apply to refinance your car loan, it could potentially save you money by lowering your interest rate (though be sure to read the fine print on those offers of 0% interest).
But it’s important to know that refinancing does cause a hard inquiry on your credit report. A hard inquiry is when a financial institution or lender does a credit check to see whether or not you’d make a good candidate for the loan. Every hard inquiry will drop your score by a few points and remains on your credit report for two years.
If you do “loan shopping” and get quotes from a few different lenders in a short period of time (usually 30 days) the credit bureaus will often treat this as just one hard inquiry. But if you spend 6 months looking at refinancing options, that will likely result in several hard inquiries on your credit report. For this reason, it’s a good idea to limit any applications to the same 30-day period. Multiple hard inquires can significantly decrease your credit score over time and show that you might be desperate for credit.
How Car Loans Affect Your Credit
An auto loan can be used as a good tool for proving your credit worthiness, and your ability to pay back a larger debt. But it can backfire if you can’t make the payments or get stuck with an underwater car loan in the “new every two” cycle of buying new vehicles (if you need help getting out of debt, ReadyForZero can help).
Like with any other debt, it’s important to understand the risks involved before taking on that challenge, and to use it strategically towards building credit and a solid financial history.
Image credit: iMorpheus’ photostream