A car loan can potentially increase your credit score by diversifying your credit mix and demonstrating responsible repayment behavior, such as making timely monthly payments over the loan term. However, it’s important to manage the loan responsibly to avoid negative impacts on your credit score, such as missed payments or excessive debt relative to your income.
In January 2024, the average cost of a new vehicle exceeded $47,000. Most consumers have much less than $47,000 saved, making auto loans an important type of credit. Before you apply for this type of loan, however, you likely want to understand its potential impact on your credit profile.
So, do auto loans build credit? It depends on how you manage your account. Some people benefit greatly from taking out auto loans, while others hurt their credit with irresponsible behavior. Discover how to use an auto loan to improve your credit score.
Auto Loans: An Overview
If you don’t have enough cash to purchase a vehicle, you can take out an auto loan, which is a type of installment loan. Installment loans have fixed monthly payments, making them fairly easy to manage. All you have to do is make your payment as scheduled. There’s no need to track variable interest rates or calculate a new payment amount every month.
When you apply for an auto loan, the lender checks your credit profile to determine if you’re likely to repay the money you borrow. This can add a hard inquiry to your credit reports.
Some lenders report to Equifax, Experian, and TransUnion, while others report to just one of these credit bureaus. Personal loans, student loans, and mortgages are also classified as installment loans.
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Do Car Payments Build Credit?
Taking out a car loan can affect your credit in several ways. As mentioned previously, a hard inquiry appears on your report every time a lender checks your credit history to determine whether to approve or deny a credit application. A new inquiry may cause your credit to take a small hit, but it should rebound if you maintain a history of responsible credit usage.
Consumers run into problems when they can’t make their car payments on time. If you’re a few days late on a payment, the lender may charge a late fee. Once a payment is 30 days late, however, the lender can report it to the credit bureaus. Having a 30-day-late payment may decrease your score more significantly, especially if you had excellent credit before the missed payment.
If you continue to miss payments, your score will drop even more, making it difficult to qualify for loans and credit cards.
On the other hand, when you get an auto loan, your payment history will be reported to the credit bureaus. Because your payment history makes up a large portion of your credit score, as you consistently make payments on time, your credit health will likely improve. So if you manage your car loan responsibly, it can be great for your credit.
In addition, by getting an installment loan to finance the purchase of a new car, you add to the installment category of your credit mix. And the more diverse your credit mix is, the better it is for your credit. This is because lenders notice that people who are more reliable in paying multiple different types of accounts are less likely to default on their debts.
What You Need to Know About Credit Scores
Lenders rely on multiple scoring models to determine if they should approve your loan and credit card applications. As a result, some people find credit scores a little confusing. Here’s what you need to know to build a strong credit profile.
What Factors Are Used to Calculate Credit Scores?
The scoring models used by the Fair Isaac Corporation, better known as FICO®, use five factors to determine your credit scores:
- Payment history. As we just mentioned, making payments on time is one of the best ways to build credit, as payment history accounts for 35{e6a1e97ec1a15155ca0ed8c3e87721e561c99ed6e52274045963a20278fc2089} of your FICO score. Lenders look at your payment history to determine the level of risk involved in loaning you money. If you have several late payments, you may not qualify for an auto loan with a reasonable interest rate.
- Amounts owed. It’s okay to have loans and credit cards, but it’s important not to borrow more than you can afford to pay back. If you’re using the majority of your credit limit, lenders may wonder if you’re struggling to meet your financial obligations. Try to use less than 30{e6a1e97ec1a15155ca0ed8c3e87721e561c99ed6e52274045963a20278fc2089} of your total credit limit, if you can.
- Length of credit history. The length of your credit history is based on your average age of accounts, the age of your oldest account, and the age of your newest account. Although you don’t need a lengthy credit history to achieve good credit, it can definitely help. A long history of using credit wisely may give lenders more confidence in your ability to make loan payments on time.
- Credit mix. Credit mix refers to the different types of accounts in your credit profile. Some lenders want to see that you have experience managing auto loans, credit cards, and other types of credit before they approve your application. Fortunately, you can still build credit with a single auto loan.
- New credit. Lenders view multiple hard inquiries within a short amount of time as a sign you may be in financial trouble. There are some exceptions for consumers who are shopping around for auto loans and mortgages, but it’s best to keep the number of inquiries on your reports to a minimum.
What Is a Good Credit Score?
Some lenders issue auto loans to consumers with poor credit, but many companies want to see good or excellent scores before they’ll loan you money to buy a vehicle. In that case, it’s important to know what a good score is.
FICO scores range from 300 to 850. The closer you are to 850, the more likely it is you’ll qualify for loans and other types of credit. However, a good score generally ranges from 670 to 739. If your score is even higher, you may qualify for the lowest interest rates and most favorable terms.
What Are Some Ways to Improve Your Credit?
If your credit isn’t as good as you’d like, don’t panic. You may be able to improve it with the following methods:
- Make on-time payments. Remember, payment history is the most important factor used to determine your credit scores. If you want high scores, you’ll need to make your payments on time.
- Avoid taking on too much debt. It’s okay to have multiple credit accounts, but the more accounts you have, the more money you owe each month. To avoid late or missed payments, take on only as much debt as you can afford to repay.
- Pay down your existing balances. Your credit utilization ratio compares the amount of debt you have to your total credit limit. For example, if you have $20,000 in debt against credit limits totaling $100,000, you have a utilization ratio of 20{e6a1e97ec1a15155ca0ed8c3e87721e561c99ed6e52274045963a20278fc2089}. High utilization can affect your scores and make it less likely you’ll qualify for loans, so try to pay off your revolving debt as much as you can each month.
- Request a credit limit increase. If you don’t have enough cash on hand to pay more than the monthly payment on each account, request a limit increase from your lenders. Increasing your credit limit without increasing the amount of debt you have can result in a lower credit utilization ratio. Using the previous example, if you have $20,000 in debt against a new limit of $125,000, your utilization ratio drops from 20{e6a1e97ec1a15155ca0ed8c3e87721e561c99ed6e52274045963a20278fc2089} to 16{e6a1e97ec1a15155ca0ed8c3e87721e561c99ed6e52274045963a20278fc2089}.
- Dispute credit report errors. About one-third of consumers have at least one error on their credit reports. These errors can cause your credit to drop significantly, making it difficult to qualify for the credit products you need to achieve your financial goals. Fortunately, you have the right to dispute errors with the major credit bureaus. If you decide to dispute an error, submit your request in writing, and be sure to keep copies of all correspondence related to the dispute.
Using Auto Loans to Build Credit
The bottom line is that car payments build credit if you manage your loan wisely. To reap the benefits of having a car loan, make your monthly payments on time. If you encounter any financial difficulties, explore other repayment options, such as refinancing your auto loan to take advantage of a lower interest rate.
