How Do Car Loans Affect Your Credit Score?

How Do Car Loans Affect Your Credit Score?

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.

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

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  • Leigh Car Finance

    Online there are variety of car loans company but you get help from the broker then you will have a good deal.

  • Johan Fourie

    Totally agree with you,,,thanks for sharing it !

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Thanks, Johan!

  • Pedro Torres

    What if you can pay off your car loan with a balance transfer of 0% interest rate and be able to continue doing the same payments you are doing to that bank? Will it look weird in the credit score? It is better to have a car loan that a credit card with a balance? ( I have done balance transfer in the past and I have been able to pay all of them). So I did the math and I save like $200 in interest rate for the whole period. But with this article now I think that if I am planning to buy a house within one year, I have to consider that a credit card deb is worst than a car loan deb from the banks point of view?.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Pedro, this is a hard question to answer because car loans are seen as secured debts and those loans are viewed as installment loans. This means they are viewed a little differently on your credit report than a credit card debt, which is considered an unsecured debt. Having a history of on-time payments for an installment loan could be a good thing for your credit score, but I’m not sure how much difference it would make in one year. I don’t think the balance transfer (to pay off the car loan) would hurt your score, but I can’t say for sure if your score would be lower or higher if you choose one option or the other.

  • David

    Nice article, thanks.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Glad you liked it! Thanks for your comment.

  • Nikki Smith Forshey

    i have a question .my husband and i were told a few months ago that our credit score wasnt high enough to qualify for a mortgage loan, but if we kept making payments on our new truck on time that our credit would go up after paying a years worth of payments. that year is coming up and i just need to know how long after the payment is made will it take our credit score to go up?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Nikki, I don’t think it is a hard fast rule (i.e. your score goes up after exactly one year). In general, as you continue making on-time payments your score will continue to increase. If you’re ready to get a mortgage, you may want to apply again and see if you’re approved. Or you can use one of the online tools to see your credit score for free.

  • Joseph

    You are fined before you commit the crime! The gov does not require constututional due process by big business. Just pay every penny of that bill a week in advance and shut up!

  • Eric Medina

    My car payment is $259 a month If I increase my payment by at least $100 will it help my score rise?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Eric, as long as you are paying the agreed upon amount every month, it will help your credit score. Paying $100 more per month does not necessarily help your credit score, but you can always do it in order to get out of debt faster. Hope that helps!

  • Karol Montoya

    I have paid 21 months of my car payment but I want to return it to the financial insitution, how bad will this affect my credit? And around how much ha these 21 payments helped it? If it has any.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Karol, that depends on whether it is a lease or a purchase. If you purchased the car and are not able to continue making payments then that will hurt your credit because it will be marked as an account not paid in full on your credit report. However, if you work out an arrangement with the dealer or lender to return the car (known as a “voluntary repossession”) then you might be able to avoid some of that damage to your credit. You could even ask them to refrain from reporting it to the credit bureaus. Also, remember that even if your credit score takes a hit, you can still work to improve it in the future. Over time, it will bounce back.

  • Pablo Olvera

    Hi, so I’m debating on what steps to take to help my credit score and save a few bucks in the process. I have an auto loan and have been making payments for close to a year now. I have extra cash in my savings so I could pay off the loan now and not have to worry about paying any interest. Would that be a smart choice or should I keep making payments on it?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Pablo, the auto loan definitely plays a role in determining your credit score. If you make all the payments on time as agreed in the contract it will look very good and have a positive impact on your credit score. In terms of paying it off early, I’m not sure how much that would change its impact. If anything, it might not have quite the same impact. But I’d recommend doing a little more research to find out for sure. Here’s one article that might be helpful:

      http://blog.creditkarma.com/credit-101/credit-scores/building-credit-with-an-auto-loan-or-car-payment/.

  • Kris

    I have a question. My husband and I can no longer afford the car we purchased almost a year ago, if we returned the vehicle to the dealership, how bad out how much will or credit score drop? We’re very stressed on trying to come up with money to make the payment. Any advice please!

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Kris, I’m sorry to hear about this situation. It must be very frustrating. I can’t say exactly how much it would hurt your credit score because it depends in part on how the dealership/lender responds. I would suggest calling the lender and asking them about your options. They may be able to help find a solution that works for you and them.

  • Dee Julian

    I recently paid off an $18K auto loan early and got pre approved to buy another vehicle from the same financial institution at a much better interest rate. I purchased another vehicle for $28K with that new loan. Before I started all this my score was 810 based on my great credit history. While I still have no credit card debt I now have a much larger car loan debt. What do you think will happen to my score?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Dee, your score might go down slightly but I don’t think it would affect it too much. However, I don’t know for sure – let us know how it goes!

  • someone_stole_my_username

    For everyone asking about returning a car to the dealership, you cant do that. You dont own the car, the finance company does.

    All the dealership will do is offer to buy it from you. If you owe 10k and the dealership offers you 6k, you still owe the finance company the remaining balance. Your payments will continue, the only difference is you no longer have a car. Your other option is to sell it privately. You’ll get more money than you would from a dealer, but i can almost guarantee, not enough to pay off your loan.

    The catch, is as soon as the finance company finds out you sold it, the entire remaining amount becomes immediately due. Not paying that remaining balance puts you in the same situation as a repossesion. Legally, in most states, the vehicle can be, and will be, repossed from the new owner. You have just placed yourself in a huge financial crisis. You now have a repossesion on your credit, you owe additional fees for the towing and whatnot., and you owe the buyer their money back. If you gave that money to the finance company, be ready to be sued because the finance company isnt giving it back.

    Because of this fact, many people end up trading the car in instead for something cheaper. They are then put severely underwater with a longer term loan in order to keep the payment cheap enough for them to afford. Having worked at a dealership, chase auto, and hsbc auto, I’ve seen it plenty of times. People trading in a 20k car for a 10k car and owing 16k out the door with a 72 month payment. All they did was go from a $400/mo to a $300/mo payment.

    Now, there are going to be people that say I’m wrong and they were able to turn their car into the dealership. That’s called surrendering the vehicle. It needs to be set up with the finance company before hand, and you dont have to drop it at a dealership. They will come pick it up. It’s no different from a repossesion because it is still a repossesion. No matter what you do, you will still take the hit to your credit and it will remain on your report for 7 years.

    If you cant afford your car payment reach out to your finance company. There are programs to get you back on track, refinance, or lower your payments whether its temporary or permanently. When you qualify for these programs will depend on the bank. Some are available immediately, others, not until you’ve been in default for a certain amount of time. Either way, it’s better than having a repossesion on your credit.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Wow, very insightful comment! Thanks so much. Would you be interested in turning this into a blog post to be published on our blog here? I think our readers would enjoy it, and I could work with you to expand it into a blog post. Let me know!