In the Credit Driver’s Seat: Does Financing a Car Build Credit?
Financing a car can build credit if managed responsibly.
Contributing Writer at Tally
August 19, 2022
If you’re buying a car for the first time, you probably have many questions. In addition to whether you should buy new or used, you might wonder, “Does financing a car build credit?”
Below, we discuss:
How financing a car affects your credit score
If purchasing a car is the right credit-building option for you
Some helpful tips for financing a car
Does financing a car build credit?
Know that taking out an auto loan could ultimately help build your credit, assuming you manage it responsibly. However, it can also negatively impact your credit.
How financing a car can positively impact your credit score
If you make minimum monthly car payments on time, you’ll improve the payment history factor in the FICO scoring model. This accounts for 35% of your FICOcredit score, giving it the most weight in the FICO scoring algorithm. So, making on-time payments can go a long way in improving your credit score and building credit.
When you take out a new car loan, three main components determine your monthly minimum payment:
Principal amount borrowed is the total loan amount, including fees. The higher the principal amount borrowed, the higher your monthly payment
Interest rate is the amount your lender charges for borrowing money. The higher the interest rate, the higher your monthly payment
Loan term is the number of months you have to repay the loan. Generally, the longer your loan term, the lower your payment. However, your interest rate will go up with the term, meaning you pay more for the vehicle over time.
An auto loan can help balance your credit mix. Credit mix refers to the balance of revolving credit (credit cards, lines of credit, etc.) and installment loans (personal loans, car loans, home loans, etc.) you have. If you have only revolving debts, adding an auto loan balances the types of credit accounts on your report. This could improve your credit mix, which accounts for 10% of your FICOcredit score, potentially improving your score.
How financing a car can negatively impact your credit score
Although auto financing can improve your credit score, it can also harm it. Missed or late payments will negatively impact your payment history factor and could significantly lower your credit score.
If you default on the loan, you’ll likely end up with the loan in collections and a repossession on your credit report, which can result in a FICO Score drop.
When you apply for your loan, your lender performs a hard inquiry on your credit profile. This happens whether you secure your lending through a dealership or a third-party lender like a bank or credit union.
A credit inquiry negatively impacts the new credit factor in the FICO scoring model, which accounts for 10% of your score. This inquiry on your credit report may cause a slight credit score decrease —typically five points or less. This is not exclusive to auto loans either; it’s something all borrowers deal with whenever they attempt to secure new credit, whether for an auto loan, student loan or credit card.
Fortunately, your on-time payments can quickly negate a slight credit score dip from a credit check.
Does paying off a car loan help build credit?
You may think the answer to this question is obvious, but it’s not as simple as you may think. Yes, less debt is generally a good thing, but some debt can be helpful when building credit.
If you pay off your car loan early and never had any late payments, the account will continue helping your credit score until it’s removed from your credit report for up to 10 years. However, active and current credit accounts have far more impact on your credit score than paid-off accounts. So, if you’re looking to maximize your car loan’s impact on your credit score, it’s best to continue making the monthly payments.
But, there are times when paying off a car loan early makes financial sense, such as if you:
Have a high-interest loan: If your credit only qualified you for a high-interest loan —6% APR or higher — you may want to consider paying it off early. Alternatively, if you’ve made significant credit score improvements since taking out the loan, you can refinance into a lower-interest loan and continue making monthly payments.
Want to improve your debt-to-income (DTI) ratio: If you want a mortgage or other loan, and your auto loan is pushing your DTI ratio (monthly income divided by monthly debt payments) is too high, you may want to pay off the car loan early.
Have other installment loans: If you’ve built a balanced credit file that includes a relatively equal share of revolving credit and installment loans, you can likely pay off the car loan and continue building your credit with the other debts.
Is a car loan a wise option to help build credit?
Now that you know financing a car can build credit, let’s discuss whether or not car financing is a wise option for building credit.
A car loan can be a good option for building credit when you use it wisely. Here are a few reasons why:
Take advantage of a need: A car is likely necessary if you commute to school or work. You might consider taking advantage of a car loan to aid your credit score.
Cash in on future resale value: Your car’s value will depreciate over time, especially if you buy a brand-new vehicle. However, once you’ve paid off your auto loan, you own the vehicle and are free to sell it or take advantage of its trade-in value. You don’t have that advantage when building credit in other ways, like with credit cards.
Enjoy fixed loan payments: Car loans have a fixed monthly payment and loan term, so you know how much you pay in principal and interest monthly. You also know how long you will make payments, making it easier to work the payments into your budget. When you use a credit card to build credit, your monthly payment will vary based on your balance and the variable interest rate.
How can I keep my car payment within my budget when financing a car?
When financing a car, these tips can help lower your monthly payment, making it easier to stay on budget throughout the loan’s term:
Put money down: Put as much extra cash as possible into a down payment on the car. This reduces the total amount you need to borrow and could also reduce your interest rate.
Shop around: Just because you have nonexistent or poor credit doesn’t mean you should take the first loan offer you come across. Shop around for the best rates; securing a lower interest rate could save you money in the long run.
Consider the total cost: Though the sticker price should be a primary concern, it shouldn’t be your only concern. Car insurance, maintenance, repairs, and fuel can add up. You may be able to afford the car payment, but can you afford to insure, fuel and maintain it for the full loan term? Consider these costs when determining a car’s affordability.
It’s easy to make an emotional decision when you walk into a car dealership, but being patient during the buying process can benefit you in the long run.
What are some mistakes to avoid when it comes to auto financing?
Because the car-buying process can be so fast-paced, it’s easy to make mistakes. Below are a few common ones to avoid:
Focusing only on new cars: New cars depreciate by 10% as soon as you drive them off the lot. Several-year-old used cars are often just as safe and reliable as new cars. You can also focus your search on certified pre-owned (CPO) vehicles, which generally include a manufacturer’s warranty and sometimes have special financing rates.
Not negotiating: Dealers often have wiggle room in their asking prices and interest rates. Whether you negotiate loan rates, pricing or upgrades, like free service for the first year, you can look for ways to get a better deal.
Not thinking about financing until you arrive at the dealership: You should do your homework ahead of time and understand where you stand financially. Know how much you are willing to borrow and how much you can fit into your monthly budget. You can even secure financing before going to the dealership and walk in like a cash buyer, giving you leverage in the negotiation process.
What to do if you can’t secure a car loan
If you can’t secure a car loan due to bad credit or a limited credit history, there are still other ways to build credit.
Look into various credit cards designed for those with little to no credit. You may have a higher interest rate than average, but if you pay your balance in full every month, the interest rate should not be a concern. Once you’ve built up some credit history, you can upgrade your credit card to something more favorable and secure auto financing. This, in turn, will improve your credit mix and score.
If you don’t have time to build credit this way and need a car immediately, you can consider a co-signer. The co-signer signs onto your auto loan and agrees to make payments on your behalf if you do not make your minimum payments on time each month. A co-signer should be someone you trust, like a family member or a close friend.
Remember, if you are late on the monthly payment or default on the car loan, the cosigner will likely receive the same negative payment history mark on their credit file. So, before involving a cosigner, make sure you’re financially able to manage a car payment.
Does financing a car build credit? Yes, if you do it right
Building credit is a great first step toward financial independence. And now that you understand the role financing a car plays in building credit, you have a potential pathway toward a good credit score.
An auto loan can help build your credit score if you make your monthly loan installments on time and in full. Still, financing a car for the first time can be overwhelming, but it doesn’t have to be. Doing your homework ahead of time can help you make an informed decision.
If you have existing credit card debt preventing you from financing a car, look into Tally†. Tally will help you pay down your higher-interest credit card balances efficiently with a lower-interest line of credit.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.