Have you ever thought about how auto loans impact your credit score? Probably not, unless you’re obsessed with credit scores. Although improving your credit score shouldn’t be your primary reason for getting an auto loan, it’s good to know how it will affect it.
So, what’s the low-down on auto loans and credit scores?
How Auto Loans Impact Your Credit Score
Before we dive any deeper, let’s examine the five components that determine your FICO score.
- Payment history (35%):
Do you pay your credit accounts on time each month? Payment history is the essential component of your FICO score.
- Amounts owed (30%):
How much do you owe in proportion to your available credit? This is also known as your debt to available credit ratio.
- The length of your credit history (15%):
How long have you been using credit?
- Credit mix (10%):
What types of credit accounts do you have? This includes credit cards, mortgages, and installment loans.
- New credit (10%):
Have you recently applied for new credit?
Will Taking Out An Auto Loan Improve Your Score?
When done right, an auto loan can help improve your credit score. However, if you aren’t careful, the impact could be the exact opposite.
How Auto Loans Help Payment History
Most lenders report your payments to one or more credit bureaus. Your FICO score will improve if you make timely payments each month. This is a great way to rebuild your payment history if you’ve had a few missteps in the past.
How Auto Loans Impact Your Credit Utilization Ratio
FICO does not considers how much you owe on installment loans when calculating your credit utilization ratio. Your credit utilization ratio only takes into account revolving credit accounts, such as credit cards and lines of credit. Credit score algorithms do take into account your overall debt is, so an auto loan may drop your credit score by a few points at the beginning. However, “paying down installment loans is a good sign that you’re able and willing to manage and repay debt” (source)..
How Auto Loans Build Credit History
If you have a short credit history, taking out an auto loan can give you a head start. Auto loans usually last for 12 to 60 months, which — if you’re on time with your payments — will add plenty of positive items to your credit report.
How Loans Help Credit Mix
Lenders like to see a combination of revolving and installment loans, especially if you’re a credit newbie. Although credit mix only accounts for 10 percent of your FICO score,
It will be more important if your credit report does not have a lot of other information on which to base a score,
Ways Auto Loans Can Hurt Your Score
If you’re not careful, there are several ways auto loans can damage your credit score. These include:
- Late payments:
One late payment can tank your FICO score. The good news is you’ll have 30-days to bring the loan current before it’s reported to the credit bureaus.
A repossession can lead to a collection or judgment being reported on your credit report. Both items remain on your credit report for seven years.
- Credit inquiries:
A hard inquiry will be generated for the initial loan application and if you decide to refinance the loan later on down the line. Fortunately, each hard inquiry only decreases your score by five points or less, and the impact is only temporary.
Before applying for any type of loan or credit, it pays to understand how it will impact your credit. This article provides practical ways you can improve your credit score.
Read this article if you need an auto loan but you have bad credit.
The Bottom Line
An auto loan can help improve your credit score if you make your payments regularly and on time. However, it’s an expensive way to improve your credit. Getting a credit building loan, applying for a new credit card, or — even better — reducing your credit card debt are all more cost-effective methods of improving your credit score.
Allison Martin is an accomplished finance writer who has written for publications including The Wall Street Journal, MoneyTalksNews, The Simple Dollar, and Credit.com. Her work has been featured on Fox Business, Yahoo! Finance, MSN Money, and ABC News. She enjoys writing about personal development, entrepreneurship, personal finance and is a Certified Financial Education Instructor (CFEI).