how a car loan affects your credit
Photo by Wolfgang Rottmann on Unsplash

We build credit to be able to use credit, but there are times when we’re afraid using it will damage the credit we’re trying so hard to build. If we go back and forth on it too much, it can begin to feel like a bit of a trap.

The truth is, the point of building credit is to have access to more financial products. Yes, they might affect our credit when we open them, but there are things that can be done to minimize any negative effects and maximize the positive. In light of that, here are some ways an auto loan can affect your credit — and why it’s more important to focus on the effect your credit has on the ability to obtain an auto loan.

How an Auto Loan Affects Your Credit

Other than things like defaulting on an account, declaring bankruptcy, and maxing out credit cards, there are few things that affect your credit in an entirely negative or positive way. Rather, effects on credit are more of a give and take. In the case of auto loans, here are the simultaneously positive and negative ways they can affect your credit.

How an Auto Loan Negatively Affects Your Credit

For an auto loan, the time most likely to negatively affect your credit is in the beginning of the process. That is, when you’re applying for a loan and when you originate one.

When you submit a formal application for a loan and a lender processes it, your credit score can get a “hard credit inquiry.” These inquiries usually only take a few points off your scores, and aren’t something to worry about unless you’re doing them all the time.

That said, you’ll probably want to shop around for the best rates you can get. In that case, here’s a method to help you avoid getting multiple hard inquiries:

  1. Apply for pre-approvals or prequalifications (which should only do a soft credit inquiry) so you can see the terms different lenders might offer you
  2. If you do more than one formal application, make sure they’re all for the same amount of money, that they’re all auto loans (no other credit applications at this time), and within a short period of time (two weeks is best)

The latter step is something that can show lenders you’re rate-shopping, and that you don’t intend to take out every loan you’re applying for.

Once you originate a loan, your total debt amount will experience a sudden increase, which can temporarily negatively affect your credit scores. However, as you make payments each month and the balance decreases, that effect can diminish.

Finally, an auto loan can negatively affect your credit if you pay late or miss a payment. Late and missed payments can be much more damaging to credit than applying for and taking out a new loan. As long as you pay on time and in the full amount due each month, you can ensure that the only negative effects of your auto loan are the minimal ones that happen in the beginning.

How an Auto Loan Positively Affects Your Credit

Speaking of payment history, that’s a straightforward way to make sure your auto loan positively affects your credit. Since it is such an influential factor in FICO® credit scores, the act of making on-time payments every month can help build and improve credit. The benefit of that act alone can grow as the balance on your auto loan decreases with each monthly payment.

There’s another, perhaps less well-known, factor in your credit scores that can be aided by your auto loan: Credit mix. Credit mix is the mix of different credit types you have, such as an auto loan and a credit card, student loans and credit cards, and so on. The more of a mix of credit types you have in your credit profile, the better your credit mix is. This is a factor that can enable lenders to see how well you handle different types of credit (or their specific type), so showing it can be positively impactful on your scores.

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Auto Loans Plus the Cost of a New Vehicle

When you think about the relationship between an auto loan and your credit scores, it can be more beneficial to think about how your credit scores affect your ability to get an auto loan (and what interest rate you might be given). The better your credit scores, the more likelihood of credit approval — and the better the likelihood of getting a lower interest rate.

Interest rates on credit can change the outcome of what you’ll pay on a loan in a big way. When you start doing the math on even a half percent or one percent increase in interest paid out over the life of a loan, you’ll be able to see just how much of a difference it can make.

In April of 2019, car information website Edmunds noted a trend in which they saw more car buyers than in the past getting “pushed into higher financing brackets.” More specifically, Edmunds noted that the percentage of consumers paying a 10 percent or higher APR had grown to levels not seen since February of 2008.

That’s not the only trend affecting car buyers’ bottom lines. Kelly Blue Book noted in May of 2019 that the average price of new cars went up two percent from the previous month. Put into dollars and cents, the “average transaction price for a light vehicle in the United States was $36,843 in April 2019.”

Increasing interest rates plus increasing car prices can mean higher monthly payments on your auto loan, and more money paid for your car overall. The best way to mitigate these effects (besides making a large down payment or setting a car budget you won’t need as much financing for) is to make sure your credit is as good as it can be before applying for the loan.

How to Prepare Your Credit for an Auto Loan

If you know an auto loan is in your near future, the time to start working on your credit so you can get the best possible interest rates for you is now. Here are a few steps that can help:

  • Make all payments on all credit accounts in full and on time
  • Reduce revolving debt (such as credit card debt) by paying down your balances as much as possible
  • Monitor your credit reports and dispute any errors you might find
  • Deal with any collections accounts you may have — such as setting up a payment plan to bring them current or otherwise negotiating with the debt collectors

The good thing about the work it takes to improve credit is that a few consistent steps can go a long way — if they’re the right steps. Following steps like those listed above can help you do what’s in your power to achieve a “yes” on your auto loan application — and, hopefully, a “yes” with a reasonable interest rate.

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