If you’re thinking about purchasing a car but are worried about how it will impact your credit score, don’t fret. Most car shoppers take out loans to finance their new vehicles, and if you are diligent about making your car payments on time, taking out a car loan can help you improve your credit score.
To best answer the question of does a car loan help my credit score, first let’s dive into everything you should know about credit scores and then explore the scoring impact an auto loan has on your credit.
What is a Credit Score?
A credit score is a number that depicts your creditworthiness—how well you handle your credit and debt obligations. Ranging between 300 (poor) and 850 (excellent), your credit score generally represents how likely you are to pay your bills on time.
Generally, the higher your credit score, the more favorable your credit terms will be, such as smaller payments and less interest over the life of your account.
What is Your Credit Score Based On?
Your credit score is calculated based on several factors that are included in your credit reports. These include:
Payment history details how you have paid your accounts over the total length of your credit. Payment history accounts for more than 30% of your credit score and, therefore, can have a significant impact. By missing just one payment, you can negatively impact your credit score. To maintain or improve your credit, make sure you pay your bills in full and on time.
Credit utilization measures how much of your available credit you are using and makes up about 30% of your credit score. Your credit utilization ratio takes the total credit you are using and divides it by your total credit limits to show how much credit you’re utilizing and how much you’re relying on credit versus cash.
For instance, if your credit balance is $500 and your credit limit is $5,000, your credit utilization for that account is 10%. Typically, creditors frown upon using more than 30% of your available credit. If you begin to use more than 30% of your available credit, your credit score could start to drop.
Average Age of Credit
The length of your credit history is also a determining factor of your credit score, making up about 15% of your score. How long you’ve held credit includes the ages of your oldest and newest credit accounts, and the average ages of all accounts. In general, the longer your credit history is, the higher your credit score will be.
For a higher credit score, it’s also essential to have a diverse credit mix. For instance, utilizing an array of credit accounts, such as a credit card, car loan, mortgage, and education loan, can indicate to lenders that you do an excellent job managing a mix of credit products.
A credit inquiry is simply when someone, such as a lender, looked at your credit report. Credit inquiries also impact your score, but overall, they are the least important factor of your credit score. While too many inquiries, such as recently opened accounts and hard inquiries from lenders when applying for credit, can lower your score, the change in your score is usually relatively small and temporary.
How to Get Credit Scores and Reports
You are entitled to annual copies of your credit report from all major credit reporting bureaus, including Experian, Equifax, and TransUnion.
To get your credit score, you can check your credit card or loan statements, as most major credit card companies and others will provide monthly credit scores. Or, you can use a credit score service, many of which are free.
Regularly monitoring your credit score will not negatively impact your score and help you ensure accuracy and make informed decisions before applying for a car loan or other type of loan.
Different Credit Scores and Score Ranges
There are two main types of credit scores used by the major credit bureaus—FICO and VantageScore.
FICO scores range from 300 to 850, with five different score ranges:
- Poor credit—300-579
- Fair credit—580-669
- Good credit—670-739
- Very good credit—740-799
- Exceptional credit—800-850
Having a FICO score of 670 or higher can help you secure lower interest rates for your auto loan and other loan types.
VantageScore is an alternative to FICO that uses the following score ranges:
- Very poor credit—300-499
- Poor credit—500-600
- Fair credit—601-660
- Good credit—611-780
- Excellent credit—781-850
Having a VantageScore of 661 or higher can help you get approved for credit with more competitive rates.
Both credit score types take payment history into account, but VantageScore emphasizes credit age and utilization factors. It’s important to note that every lender utilizes different scoring systems, so you should always ask your lender which one they use when applying for a loan.
How Car Loans Impact Credit Score
When you apply for a car loan, a new inquiry will be added every time a lender reviews your credit report, and your credit report will show each inquiry. However, this is nothing to worry about.
Credit Inquiry Impact
If you’re applying for an auto loan with multiple lenders in a short time, credit scoring systems recognize that you’re shopping around for the best deal and only buying one car. In this case, they typically treat each of these inquiries as just one inquiry, or in the case of some new scoring systems, they may not count inquiries for auto loans at all.
If a hard inquiry is added to your credit report, remember that this will only temporarily lower your score by a few points.
Change in Credit Score
Once your car loan is approved, and you purchase the new vehicle, the new debt will be added to your credit report. While your credit score may drop initially due to the lack of payment history associated with the loan, your score will increase as you start making payments on time.
By making full, on-time payments, you are signaling that you are responsible with this new debt and, therefore, increasing your credit history. When this happens, you will usually see a significant improvement in your score within a few months. Additionally, getting an auto loan can contribute to a better credit mix, positively impacting your credit score.
While a car loan may initially lower your credit score, taking out an auto loan can benefit your credit in the long run. A car loan can help your credit score by creating a better credit mix and increasing your credit history when payments are made on time.
To help your credit score even further, you can be a responsible buyer by adhering to your credit card issuer’s legal terms and paying the full amount of the bills you’re already paying on time.
To regularly monitor and maintain a good credit score, use your lender’s online banking features, or utilize a free credit scoring service.