Your credit score has the potential to impact so many different aspects of your life. A good credit score is a hallmark of healthy finances. If you are considering buying a car, you will likely be applying for a car loan to complete your purchase. To prepare for working with auto lenders, it could be a good idea to read up on what credit score might be necessary to get approved for a car loan and how you might be able to improve your credit score to get better interest rates.
How an Auto Loan Works
The average middle-class American does not have the means to purchase a car with cash outright. Which is why a majority of people make their car purchase with an auto loan. An auto loan, also referred to as a car loan, is a specific type of loan with monthly installments used with the express purpose of purchasing a vehicle.
To get an auto loan, you fill out an application for a loan the amount of the car you wish to purchase minus your down payment. You purchase the car with the money you borrow from the lender. Once you have your new vehicle, you will make monthly payments until the full balance of your car loan is paid off.
Similar to mortgages, auto loans are secured loans that use the equity in the car you bought as collateral. For mortgages, the borrower’s home/property is used as collateral. For auto loans, the car itself being collateral for the money borrowed means that you will need to prioritize making all your car payments on time every month. Defaulting on your car loan could result in the vehicle being repossessed by the lender.
Every auto loan will have an interest rate that is applied to the balance each year and your credit score could have a significant impact on what APR you can qualify for. Term lengths for auto loans vary between one and five years.
Why Are Credit Scores Important for Auto Loans?
Your credit score plays an important role in your application for an auto loan. Your credit is meant to represent your financial responsibility and the risk involved in lending to you. Lenders always check credit scores before approving you for a loan or revolving credit of any kind for assurance that you will pay back the money you borrow on time.
Your credit score might determine whether you are approved for an auto loan at all but it will also heavily influence what your interest rates look like. Oftentimes, a higher interest rate is used to offset the risk involved for a lender working with a borrower with a lower credit score. The more credit risk a borrower poses to a lender, the higher the cost of the loan will be through interest charges.
How Credit Scores Are Calculated
To better understand why credit scores are so important to auto lenders, it could be helpful to break down how credit scores are calculated. Knowing how credit scores work will also help you determine what you need to change in your financial habits to obtain a higher score. If your credit score is currently too low to be approved for a car loan or get the interest rate you want, you could boost your credit score by improving the information reported to the major credit bureaus.
The three major credit bureaus – TransUnion, Equifax, and Experian – compile consumer credit reports out of all information relevant to your creditworthiness including credit accounts, credit inquiries, public records, and collection accounts. These credit reports are then broken down into five categories, each afforded a different percentage, to calculate your FICO credit score.
The formula for your FICO credit score looks like this:
Payment History (35%)
The payment history on all your credit accounts is the most impactful category in your FICO score calculation. Making up 35% of the equation, payment history is recorded by the credit reporting agencies for all the accounts included on your report such as credit cards, online quick cash loans, student loans, mortgages, and auto loans.
Consistent on-time payments make you a reliable borrower so a positive payment history with minimal late or missed payments will get you a good credit score. Late payments can remain on your credit report, impacting your FICO score, for up to seven years so it is crucial to make all your payments on time to the best of your ability.
Amounts You Owe (30%)
Next, the amounts that you owe on your credit accounts make up for 30% of your FICO credit score. The most important aspect of this category is your credit utilization rate which plays a vital role in the calculation of your score. A credit utilization rate compares the total amounts you own on your credit accounts to the available credit you have. For a good credit score, borrowers are advised to keep their credit utilization as low as possible – optimally at 30% or below.
Length of Your Credit History (15%)
How old your credit history is can impact your FICO credit score greatly. A very limited credit history without older credit accounts is going to make it more difficult for you to obtain a good credit score. This section of the credit scoring model considers the age of your oldest and newest accounts in addition to the average age of all your credit accounts combined.
Credit Mix (10%)
How much diversity you have in your credit mix accounts for 10% of your FICO score calculation. More variety of types of credit will bring your credit up while an overconcentration of one credit type could bring your score down. Getting an auto loan will likely benefit your credit mix.
New Credit (10%)
Each time you apply for new credit, including auto loans, you are authorizing the lender to pull a copy of your credit report. When a lender pulls your credit report, a new hard inquiry will show up on your credit. Opening too many new accounts or getting too many hard inquiries in a short period of time can harm your credit score.
What Credit Score Should You Have for a Car Loan?
There is technically no minimum credit score that is required to be approved for a car loan. Each lender has different requirements when it comes to a minimum credit score needed for approval. Because of this, it is possible to find an auto lender willing to work with you no matter your credit score if you know where to look and are willing to pay higher interest rates. However, some of the more reputable lenders may reject your application if you cannot meet their unique minimum credit score.
Good and excellent credit scores will secure the most competitive interest rates available. You are sure to be approved and receive good rates if you have a credit score over 700. However, if you have fair to bad credit, you can expect rates nearly double what those with Good credit can get.
Can You Get a Car Loan With Poor Credit?
It is definitely possible to buy a car using a car loan despite having a poor credit score. There are lenders who are willing to work with subprime borrowers but they will be charging significantly higher interest rates to make up for the increased risk. A bad credit score in the deep subprime range under 500 points will pay a high price for their auto loan.
If you are considering an auto loan with poor credit, you will need to be very careful to prevent yourself from falling into a Debt trap. You want to be sure that you can afford the monthly payments and have the ability to repay the full balance by the end of the loan’s terms. If you want to avoid those sky-high interest rates for poor credit scores, consider takings some time to boost your credit score before applying for your car loan.
Strategies for Improving Your Credit Score
To access the best deals and lowest interest rates on your car loan, you can do certain things to improve your credit score. Taking some time to boost your credit score before applying for an auto loan can increase your chances of being approved for the amount you want. You are also almost guaranteed to be offered significantly lower interest rates than you’d get with a poor credit score.
Improving your credit score will take some consistent effort and requires that you continue practicing responsible credit habits. Every little thing can make a difference when it comes to your credit report, so it is important to be wary of how each financial decision might affect your credit score calculation.
Here are some strategies and tips you can use to boost your score substantially:
Check Your Credit Report Regularly
When attempting to make improvements upon your credit, it is a good idea to check your credit report regularly. Checking your credit often can allow you to catch errors or inaccuracies that need to be disputed before they have a chance to bring down your credit score.
If you identify any false information on your credit report, you can dispute it to the credit bureau that compiled that report. You might even catch errors that have been harming your credit for a long time without you noticing. Having false derogatory marks on your report removed could significantly increase your credit score almost overnight.
Another reason to check your credit report as often as you can is that you will be able to see firsthand what effects your efforts are having and more easily identify what you need to work on. Your credit report can act as a kind of roadmap on how to make improvements on it.
Become an Authorized User
If you have a fairly sparse credit history but wish to obtain an auto loan early on in your credit journey, you can quickly increase the average age of credit accounts on your report by getting listed as an authorized user on a friend or family member’s credit card.
When you become an authorized user on another person’s credit card account, that account is added to your credit report. If this credit account is particularly old or well-established, this will significantly improve the average age of your credit history on your report. This plus an additional excellent payment history could raise your credit score quickly.
Make All Your Payments on Time
Your payment history accounts for 35% of your credit score calculation which is the biggest portion of the credit scoring system. For this reason, late payments have a highly negative effect on your credit report. Consistently making all your payments on time for a prolonged period will rebuild your payment history and improve your credit score significantly.
If you are someone who often forgets to pay your bills on time, we recommend turning on automatic payments for your credit card bills. Doing so will ensure you are never late for a payment that impacts your credit report again. Automatic payments can make on-time payments incredibly easy.
Reduce Your Credit Utilization Rate
Your credit utilization ratio compares the amount of money you owe to the total overall credit limit you have. If you have little available credit left and high balances on your credit cards, you likely have a very high credit utilization rate which is harmful to your credit score. Most financial experts advise borrowers have a credit utilization rate under 30% to have a high credit score. The lower your credit utilization, the better for your credit.
To reduce your credit utilization ratio, pay off a few of your credit card balances and keep the accounts open to maintain your available credit. This simple action should make a significant difference in your low credit score.
Stop Applying for New Credit
Applying for credit cards, an auto loan, or other forms of credit authorizes the lender or company to pull a copy of your credit report. Everytime this happens, a new hard inquiry will appear on your credit report. When trying to improve your credit score, it is a good strategy to take a break from applying for new credit to ensure there aren’t too many hard inquiries on your credit report.
Have patience as you employ all these tactics to improve your credit as it may take a little bit of time to take effect. But consistently practicing all these credit habits will do wonders for your credit score so you can access better interest rates on your auto loan!
References:
What Is a Good Credit Score to Buy a Car? | U.S. News