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When you're driving away from the dealership in your brand-new car, you're probably not asking yourself, “Does buying a car help your credit score?” However, that's an important question to answer.
Let's find out how your credit score could be impacted by signing that car loan.
Top Ways Buying a Car Affects Your Credit
Buying a car has the potential to increase your credit score, but it can also go the other way and drop. How are you to know?
It all depends upon when and how you make the payments for your car loan. To find out if you can afford a car or not, consider if you can make timely payments, which will result in your credit score going up.
However, if you cannot make payments on time or even miss a few, you will see a negative impact on your credit scores.
If you're wondering if buying a car helps your credit, then we're here to make things clear. Here are a few ways your credit score is affected when you decide to buy a vehicle.
When you apply for a car loan, the first course of action your account goes through is a hard inquiry. Unfortunately, a hard inquiry will lead to an automatic lowering of a few points of your credit score for a couple of months. The good thing is that even though your car loan application gets forwarded to many lenders, major credit bureaus will all count as a single inquiry.
A new inquiry usually forms when a lender takes a peek at your credit history. Some of the newest systems don't even consider inquiries for auto loans at all.
Once you buy a car and acquire a loan for it, your credit report will reflect the additional debt that will impact your credit score. As soon as the debt is accepted, you will see a drop in your credit score as your liabilities increase. Depending on the price of the car and the loan amount, the fallen points may vary.
That is because you haven't made any payments yet. The drop in score is mainly due to the uncertainty regarding your ability to pay off the debt in time.
Making timely payments
Payment history is one of the most significant factors that affect your credit score. By making timely payments, you can enhance your credit score.
As you continue to make these payments, your credit score will increase steadily. Most of the time, this increase will trump the initial drop in the score and ultimately help you make your way towards a good credit score.
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Managing your credit mix
When you apply for a car loan, lenders can see a credit mix on your credit history. Your credit mix is the different sorts of credits you have, such as revolving credits, installment credits, and more. Your ability to manage a mix of various types of credits proves that you are creditworthy and will give your credit score a positive boost.
Most individuals already have ongoing revolving credit, such as using a credit card, affecting your credit utilization. Adding an installment credit in the form of a car loan and successfully paying it off in time will lead to a positive impact on your credit score.
Where to Find Auto Loans on Your Credit Report
Although sometimes, your auto loan might be missing from your credit score due to the infancy of the loan. Another reason is if the three major credit reporting bureaus, Experian, TransUnion, and Equifax, haven't yet updated the loan information on your credit score, usually because the lender hasn't forwarded the information to the credit reporting agencies.
However, if you are looking for auto loans on your credit report, the place to consult would be the Industry-Specific Score.
What is an industry-specific score?
When applying for a loan for specific purposes such as the purchase of a car, student loans, mortgages, and more, FICO will help you. They provide you with Industry-Specific Scores that will help the lenders decide on the loan terms, such as the future installments and interest rates.
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The FICO Auto Scores reflect your credit behavior in terms of any loans you have acquired and your management history concerning such loans when it comes to your auto loans. The score ranges from 250 to 900.
If you have a bad Auto Score, your future auto loans will have unfavorable terms such as increased interest rates and higher monthly installment payments.
How to Make Sure Your Credit Is Ready to Buy a Car
Buying a car and taking on a car loan is a big financial responsibility, and you should have adequate preparations if you are planning on going along with the decision. Here are a few quick tips to help you get your credit ready to buy a car.
Check your credit report and scores
Although you might be able to get an auto loan with less than perfect credit scores, you might get charged higher interest rates. So, by checking up on your credit, you will know where you stand regarding auto financing.
Pay bills on time
Whether you want to buy a house, a new car, or plan to refinance, you should always consider paying off your bills on time. That is because your payment score makes up for the most significant part of your FICO score. Making up for 35% of your total score, if you want to improve your FICO scores, you can do so by taking on under-the-table jobs to pay off any late payments that are currently due.
However, when you have multiple bills to pay off, it is only human to forget a few due dates. That is why it is advisable to set up automated payments for your bills or set up reminders or alarms on your phone.
Pay off credit card debt
The first order of business to improve your credit score is to repay your credit card debt, thus lowering your credit utilization ratio. The most optimal credit utilization lenders hope for is 30% or less.
High credit utilization scores enhance the risk level you carry in the eyes of lenders, which makes them more concerned about you as a borrower. Additionally, a low credit utilization will lower the debt-to-income ratio, which is also a good indicator of your credit history to the lenders.
Apply for credit only as a last resort
As mentioned above, an auto loan can lead to a hard inquiry placed on your credit report, lowering your credit score. Although the effects of an inquiry only last for a few months, if your credit report shows multiple inquiries in the same timeframe, you can be considered a credit risk.
The best way to avoid this is to get your auto loan pre-approved before you start comparing lenders' rates, as they make an inquiry every time a lender views your credit report. However, in the case of a pre-approved loan, the credit scoring models will treat all inquiries as a single one. Therefore it's advisable only to set up a line of credit if necessary.
Never settle for anything when it comes to your credit scores, and if you feel like there are any inaccuracies on your credit report, you should address them.
To do this, you can start a dispute regarding the item you think has been inaccurately recorded. Filing a dispute will not affect your credit score. But it might help you enhance it when you were right, and there were discrepancies present.
For example, you made a timely payment, but the lender failed to report it on time, and it shows up on your credit report as a late payment. In such a case, filing a dispute will help you get your credit scores back to where they are supposed to be.
Save up for a down payment
A down payment is a payment you make at the start of financing your car. At least a 10% down payment is necessary to be made to finance a car.
One of the reasons why saving enough money is important is because a larger down payment will help you lower your interest rates, monthly installments, and less risk of defaulting on the loan.
Fast Ways to Build a Positive Credit Score
If you have decided to finance an automobile but want to improve your credit score, here are a few quick fixes that will help you enhance your credit score.
Ask for higher credit limits
With a higher credit limit, you will have the same outstanding balance. The total credit increases will help lower your credit utilization ratio and instantly enhance your credit score.
Although getting a higher credit limit can be difficult, if you have experienced an increase in your income, you have a high chance of getting an increased credit limit.
If you know someone who has a good credit history, ask them to have you added as an authorized user adding their account to your credit report. The best part about this is that you won't have to use their card or even know the bank account to increase your credit score. It allows you to benefit from their payment histories and use their credit limits to lower your utilization ratios.
Paying off your collection account will mitigate the chances of getting sued over a debt. You can also report to the collection agencies to stop registering the debt as you have paid it off.
When checking up on your collection accounts, ensure that everything is in order and the recorded charges aren't inaccurate or too old to be on your report.
Secured credit cards
Another way to enhance your credit score is to use a secured credit card. This type of credit card is backed by a cash deposit, which gets paid upfront, and the money you use gets taken out of this deposit.
A user's ability to manage a credit mix reflects very positively on your credit history. Most people already have a revolving credit set in place, as most have a credit card.
To get a credit mix going, consider getting a loan on top of that and make timely payments. That will represent you as a person capable of managing their debt, adding to your overall credit report.
Frequently Asked Questions
Car loans can be a tricky business, and you must have some questions regarding them. Here are a few frequently asked questions that might be able to help.
Should I buy a Car with bad credit?
Buying a car with bad credit is possible. However, the interest rates offered to borrowers with bad credits are much higher, leading to them paying more than the conventional interest rates. The lenders would look at your credit history, and if you appear to have bad credits, you get the high-risk credit borrower label.
How much Will my credit drop if I buy a Car?
Although it isn't guaranteed that your credit drops after buying a car, you often experience an initial dip. An inquiry on your account to acquire a car loan causes this dip.
A hard inquiry can lower your FICO points by a total of 10 points. That will change once you begin making payments against the debt, and there remains uncertainty around your ability to repay the debt. After you have made a few timely payments, you will be able to recover from this deficit in your credit score.
This article originally appeared on Wealth of Geeks.
Marjolein is the founder of Radical FIRE. She has a finance and economics background with a master’s in Finance. Radical FIRE is a personal finance blog that helps you live your dream life through making more money and investing. We want you to reach your financial goals and have fun while doing it!