Getting a loan is a great way to build credit and, as long as you follow the terms of the loan, boost your credit score along the way. However, you should be aware that signing on the dotted line can initially cause your score to drop, but it’s generally worth it since it enhances your credit over time.
While auto financing affects every borrower’s credit score differently, new borrowers who have little or no credit history will typically see some benefits when they secure a loan and keep it in good standing until it’s paid off. But auto loans can negatively impact your credit in some ways, too, so it’s important to understand how things work.
If you’re looking to take out an auto loan for the first time, you probably have a few questions about how it affects your financial standing and whether or not it’s the right thing to do for your personal finance goals. Here are some of the most common questions about car loans and credit history to help you get off on the right financial footing.
Do Car Loans Affect Credit Score?
Taking out an automotive loan will affect every borrower’s credit differently. But, in general, there are a few things that happen when you take this step.
Initially, Car Loans Can Cause Credit Scores to Fall
Whether you’re seeking auto refinancing or going for your very first car loan, applications require a “hard inquiry,” which can ding your credit.
When you shop around for car loans, each lender will run a hard pull into your credit score to determine your creditworthiness. This causes your credit score to drop by a few points.
Credit bureaus understand when you’re shopping around for a loan, so they typically won’t ding your credit for every application. Instead, multiple inquiries for the same type of loan quotes in quick succession may count as a single hard inquiry.
Additionally, a new loan sends some signals to the credit reporting bureaus that can cause your score to drop. A new loan means a lower average age, more debt overall, and a higher debt to income ratio, which can cause your score to drop.
Car Loans Can Diversify ‘Credit Mix’ and Boost Your Score
Credit mix refers to the variation in loan types you have on your credit score. The mix of loan types — mortgages, auto loans, personal loans, credit cards, and other types of financing — can send signals to the credit bureaus about your creditworthiness. In general, lenders and credit bureaus favor diversity in a borrower’s credit history.
Having different types of loans in good standing shows lenders that you’re able to pay down many different types of debt in various categories with various interest rates. So, if you currently only have a credit card or two on your credit, adding an auto loan can help improve your credit mix and you may see an immediate boost following approval.
So, with all of this in mind, should you immediately go out and open a bunch of credit cards or apply for personal loans? No. Remember that each application requires a hard pull that can negatively affect your score. What’s more, credit bureaus and lenders see opening multiple loans at once as a red flag, so be sure to always space out applications.
Over Time, Car Loans Can Cause Credit Scores to Rise
Time is the most powerful tool in any individual’s credit-boosting toolkit. Like with any loan, consistently paying your auto loan on time each month will significantly increase your credit score and add to your credit history.
With each on-time payment, you’re proving to the credit reporting bureaus that you can pay back your loans. You’re also adding time to your average credit age, which is a positive signal that boosts your score. At the same time, each monthly payment means a lowered credit utilization, which can also boost your rating.
How Fast Does a Car Loan Boost Credit?
With this in mind, how fast, exactly, can you expect to see a spike in your score after you reliably pay down your auto loan each month? There simply is no set time frame for each borrower. You can expect your score to rebound to where it was before you took the loan in about six to 12 months and then start climbing from there if you pay on time each month.
People with little to no credit history may find that their score rebounds a bit slower, but focus on making your monthly payment on time and with each milestone — six months, eight months, etc. — you should see your score climbing steadily. The length of your credit history accounts for about 15% of your total score, so it’s important to keep accounts open and give it time.
Over time, as you grow your credit, you may consider refinancing your auto loan to a lower interest rate. When you have little credit history or a bad score, you may get stuck with a high interest rate. But as you prove to lenders that you’re responsible, they will be more likely to give you a loan at a lower rate, which can reduce your payment and overall costs significantly.
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When Used Properly, a Car Loan Can Be a Great Tool
When used properly, auto loan financing can be a great tool to build credit. However, new borrowers should never use financing a car as their primary strategy for building or boosting credit. You should only apply for and accept a car loan if you have the monthly income and budget to support it. Otherwise, you could wind up in a worse position than where you started.
On the other hand, if you’re responsible about what you can afford and only take what you know you can pay back on a monthly basis, financing a car can be used as an excellent long-term strategy to build your credit history.