Car financing can have an impact on your credit score. If you manage it properly, your credit score can improve.
Let us discuss how car financing work and its impact on your credit score.
How Does Car Financing Work?
Car financing is buying or leasing a car on borrowed money. You pay interest over the loan term when you buy a car through a financing facility.
Car financing can be availed from car dealers, banks, lending firms, and credit unions. Each type of lender offers discrete benefits to borrowers and everyone comes with some limitations as well.
Some lenders would offer easier financing approvals but would charge higher interest rates. Others would offer lower interest rates but would require a high credit score.
Financing a used car is usually cheaper than financing a new car. However, different factors including your credit score, gross income, and loan term would determine your APR and monthly payments.
How Does Car Financing Affect Your Credit Score?
Car financing can affect your credit score in both ways. If you repay the loan amount in time and don’t miss monthly payments, it can improve your credit score.
On the other hand, if you fail to make payments on time or default on a loan, it will severely impact your credit score.
Here are a few key points to consider on how car financing affects your credit score.
Hard Inquiry
Lenders will post a hard inquiry to check your credit score and credit history. A hard inquiry remains on your credit history for one year.
One hard inquiry costs you around 5-10 credit score points. It does not greatly impact a borrower’s credit score usually.
However, if your credit score is close to the next stab of a scoring category (e.g. from bad to average), it will have a significant impact.
Note: Credit bureaus count all these inquiries made within 45 days for a similar product as one hard inquiry when you compare prequalification from different lenders.
Credit Length
The length of your credit history has a weightage in your FICO score calculations. Every loan and credit facility changes the average length of your credit history.
Suppose you have two credit cards for 5 years each, one mortgage for 15 years, and a personal loan with a maturity of 10 years. The average length of your financing accounts is (30 ÷4) 7.5 years.
When you apply for a new car financing facility, it will reduce to 6 years. It means if you have fewer credit accounts, a new car financing, will have a greater impact on your credit score.
Debt-to-Income Ratio
Creditors are always keen to know your loan repaying abilities. Your annual gross income is a prime indicator of that.
When you have multiple loans and credit facilities, your debt-to-income ratio decreases. With a new car financing, your debt-to-income ratio will decrease.
You can improve the debt-to-income ratio by paying off a few credit facilities, reducing your monthly loan payments, and increasing your monthly income.
Credit Mix
A car financing facility is one type of installment loan. A line of credit like a credit card or HELOC is an example of a revolving credit loan.
Your credit mix also has a weightage in the FICO score. Therefore, if you do not have an installment loan in your credit mix, a car financing facility can help improve your credit score.
All types of installment loans in your credit profile are treated as the same. Therefore, it wouldn’t have an impact if you already have an installment loan in your credit profile.
Credit Utilization
Installment loans like a car financing facility do not have a weightage in the calculation of credit utilization.
The credit utilization rate is calculated only for the line of credit facilities like a credit card or a home equity line of credit.
A wise strategy is to keep your credit utilization around 30% at any time. However, a new car financing facility wouldn’t have an impact on your credit utilization rate.
How Can Car Financing Help Your Credit Score?
A hard credit inquiry and other factors will temporarily decrease your credit score. A car loan facility usually comes with a term of 72- or 84-months.
If you keep paying your monthly installments on time, your credit score will improve drastically. A new car financing option will also improve your credit mix.
It will also improve your average credit account length. In the long term, a car financing facility will also improve your credit history overall.
Lenders and credit bureaus are primarily concerned about your repaying abilities. If you maintain a responsible and good credit history, a car loan should help improve your credit score in the long term.
What is a Good Credit Score to Apply for Car Financing?
To avoid multiple hard inquiries, you should compare different lenders and their prequalification within a few days.
Different lenders offer different APRs for various reasons. One of the reasons is your credit score. Therefore, there is no uniformity about how good your credit score should be to apply for a car loan.
Generally, you’ll need a good credit score (720+) to get approved for a car loan.
How to Improve Your Car Financing Approval Chances?
Building and improving credit scores takes time. There is no quick fix if your credit score is low or your credit history has a negative mark like a default on a loan.
Here are a few tips for you to improve your car financing approval chances.
Repay on Time
Make monthly installments of your existing loans and credit facilities on time. It will reflect in your credit history.
Late payments or a default directly impact your credit history and credit score. Therefore, paying monthly installments on time and repaying a loan in full helps improve your credit score.
Build Credit
As mentioned above, building a credit score takes time. You should plan to improve your credit score for the long term.
Your payment history, default on loans, credit utilization, credit mix, and debt-to-income ratio are all important contributors to your credit score.
Credit History
The length of your credit history and average account life are important factors for your credit score as well.
If you are a young car loan applicant, consider a cosigner to improve your chances of approval.
Gradually build your credit history with a balanced credit mix and careful credit utilization. Keeping a consistent and clean credit history will improve your credit score in the long run.
Credit Mix
A new car financing facility can improve your credit mix. If you don’t have an installment loan already, it will improve your credit mix.
You can also add other types of financing facilities like a credit card and a line of credit to improve your credit mix as well.
Debt-to-Income Ratio
Finally, find ways to boost your debt-to-income ratio. Either you can improve your gross income or reduce your loan payments.
However, reducing loan accounts will also impact your average credit length and credit mix. Therefore, taking a balanced approach to improving all metrics will help improve your credit score.
That, in turn, will increase the chances of your car financing approval.
