Does Financing a Car Build Credit

June 5, 2023

Most car shoppers don’t have the means to buy a vehicle outright unless they have been saving for some time. Fortunately, financing is a viable option for eligible borrowers — but it begs the question that we often hear: “Does financing a car build credit?” The short answer is no; the loan itself doesn’t build credit, but making your monthly loan payment consistently on time over the life of the loan does help your credit.

In this article, Dick Hannah demystifies some confusing concepts and questions about car loans and credit so that you, as a car shopper, can feel confident buying a car and preserve the health of your credit score after the fact.

How Does a Car Loan Affect Credit?

Here’s a quick look at how a car loan can have positive and negative impacts on credit:

Hard inquiry: When you apply for a car loan, your lender will pull your credit — known as a hard inquiry — to see if you would be a responsible borrower and to determine what rates and terms you qualify for. A hard inquiry will bring your score down a few points, but it should quickly bounce back as you make consistent, on-time payments.

Payment history: People often ask, “Do car payments build credit,” Yes! This is one of the most important determining measures of a credit score. Making payments on time every month demonstrates your responsibility as a borrower and can boost your credit score over time.

Debt-to-income ratio: Your debt-to-income ratio (DTI) measures how much of your total income goes to debt. Taking on a car loan raises your total debt, which can hurt your credit if you have other high debt amounts.

Credit mix: Lenders prefer to take on borrowers who have demonstrated an ability to handle debt obligations in various forms. So to boost your credit score, you can diversify your credit with credit cards, a car loan, a mortgage, and so forth. If you don’t already have a car loan, financing your car can help your credit mix and boost your score.

Understanding Credit Scores

Let’s take a step back for a moment and talk about credit scores themselves. What is a credit score? Simply put, it’s a three-digit number assigned to every consumer that reflects creditworthiness based on several factors. Experian, Equifax, and TransUnion are the three major credit bureaus lenders use to obtain a consumer’s credit information. Credit scores usually range from 300 – 850, with 850 being pristine credit and 300 being very poor. The factors used to calculate your credit score include:

How often you make loan and credit card payments on time
The duration of your oldest line of credit (the longer your credit history, the better)
Your current balances on credit accounts
The types of credit you’ve used
How many new accounts you have

When your credit score is on the high end of the range, it shows lenders that you pose a low risk to them and that they’re likely to make back their investment. That’s why strong credit increases your chances of getting loans and favorable interest rates.

The Relationship Between Car Financing and Credit

Financing a car involves taking on new debt, which affects your credit score. But beyond this simple cause-effect relationship we’ve already discussed, your credit is also impacted by the way you finance your car:

The loan type: Auto loans can be secured or unsecured. With a secured loan, the vehicle is used as collateral, which means if the borrower defaults or stops making payments, the lender can repossess it — which can be a detriment to the borrower’s credit score. Secured loans are a lower risk to the lender, so they’re typically associated with lower interest rates. Unsecured loans, in contrast, have higher interest rates to offset the risk, but the borrower doesn’t risk losing their car upon default.

Loan term: The loan term indicates the pace at which you’ll pay off your auto loan based on your available monthly income, the cost of the vehicle, and your interest rate. If your loan term is longer, you’ll have lower monthly payments but pay more in interest in the long term, which gives you more total debt and can ding your credit. A shorter term requires larger monthly payments but can help you save money overall and preserve your credit ratios.

Interest rate: The interest rate you obtain on your auto loan also affects your credit score; if you get a high-interest rate, you’ll pay more in interest over the loan term, which adds to your overall debt and can hurt your credit.

Consider these factors carefully before you take on a car loan so you know how to avoid derogatory marks on your credit score and effectively manage the debt.

How Financing a Car Can Help Build Credit

Did you know that payment history accounts for 35% of your credit score? Considering that this factor has the most weight in your scoring calculations, on-time auto loan payments can do wonders to help you boost your credit.

Approximately 10% of your credit score is determined by your credit mix or how much revolving credit you have compared to installment loans.

Adding an installment loan like an auto loan can help you diversify and improve your score if you have mostly revolving credit. So, does a car loan build credit? In these ways, it does.

Is a Car Loan a Wise Option To Help Build Credit?

Compared to traditionally riskier avenues of borrowing, like high-interest credit cards, auto loans can be an excellent way to build your credit if you manage your money responsibly and avoid taking on too high of an auto loan payment. Stick to vehicles within your budget, and make sure to shop around with multiple lenders to find the best deals on interest rates for your situation.

After identifying a reasonably priced car and obtaining a loan with terms that work for you, you’ll make regular payments over time and demonstrate to lenders that you can manage debt responsibly, thereby building a positive credit history.

Does Paying Off a Car Loan Help Build Credit?

Yes, paying off your car loan can lower your debt and free up your income, giving you a lower debt utilization ratio that can positively impact your credit. Be wary of the adverse short-term effects, though, as closing accounts decreases the age of your credit and can lower your score. And if you decide to pay off the loan early, you’ll lose the benefits of building a long payment history that can bolster your score.

How Financing a Car Can Negatively Impact Your Credit Score

Many people get a car loan to build credit. But despite the many benefits of car loans, they can also be a detriment to your financial health if you drop the ball with your payments. If you miss a payment or pay late, your history will be dinged, and your credit score may drop. This late payment will appear on your credit reports for up to seven years! Likewise, taking on too much debt can force you to default on the loan and land you in collections, dropping your credit score and making it harder to qualify for loans in the future.

What Are Some Mistakes To Avoid When It Comes to Auto Financing?

The car financing process can be tricky to maneuver, especially if you have limited experience and don’t know what to watch out for. If you plan on obtaining an auto loan soon, keep these things in mind before finalizing any paperwork.

Don’t write off used cars. Once you drive a new car off the lot, it loses 10% of its value. You can find lightly driven vehicles with the same features and reliability for less money, so don’t limit your search exclusively to new cars.
Don’t forget to read the fine print. Before you sign any documents, read the terms and conditions to fully understand the fees, penalties, and prepayment charges associated with your loan.
Don’t be afraid to negotiate. Many dealerships are willing to budge on the interest rate or terms, and sometimes, you can even negotiate your way out of hidden fees that increase your total loan costs.
Don’t focus exclusively on the monthly payment. Yes, you want a low monthly payment, but sometimes it’s smarter to take a slightly higher monthly payment if your = goal is to get the best overall deal. It’s also important to remember that car expenses go beyond the monthly payment of gasoline, maintenance, repairs, insurance, etc. Make sure you can afford these additional expenses before taking out the loan.
Don’t go to the dealership without doing your homework first. Never show up to the dealership without researching what you can afford and what types of vehicles fit into your budget. It’s easy to get carried away in excitement and end up with a less-than-stellar deal. If you get pre-qualified or obtain financing before heading to the dealership, you may have leverage for negotiation.

5 Questions To Ask Before Financing a Car

Before jumping straight into the financing process, we’ve devised a list of questions you should have the answers to so you can ensure that the financing experience is a positive one that benefits you:

How much can I afford to spend on a car? The choice to finance a car should never put you under financial duress, and we do not recommend obtaining a car loan to build credit if money is tight. Generally, your car payment shouldn’t exceed 10% to 15% of your monthly income. Make sure the vehicle you want fits in comfortably with your other expenses.
What kind of interest rate will I qualify for? Ensuring a good interest rate is a matter of shopping around to see which lenders can offer you the lowest rate and getting pre-qualified, which doesn’t affect your credit. Make sure you have good credit (670 and above will help you get a favorable interest rate) before obtaining a loan, if possible — but don’t write yourself off if your credit isn’t there yet, as it’s still possible to buy a car with bad credit. If you can find a cosigner, they can help you obtain a lower rate and save money. A cosigner will also be beneficial if you’re a first-time buyer without an established credit history.
How long do I want the loan to be? Lenders typically offer loan terms ranging from 36 to 72 months or even longer in some instances. If you prefer a shorter term, ensure your credit score, income, and loan amount are conducive to that end.
Will I have a down payment? Figure out beforehand how much cash you can comfortably put down on a car upfront. A down payment isn’t always necessary, but the more you can put toward a down payment, the lower your overall costs will be.
What fees will get tacked onto the sticker price of the vehicle? When saving money, budgeting, and calculating expenses, don’t forget to factor in sales tax, title and registration, dealer fees, and other miscellaneous fees you might opt into, including vehicle upgrades or extended warranties.

What To Do if You’re Struggling To Make Your Car Payment

Over the term of your loan, your life’s circumstances may change, whether due to the loss of a job or change in salary, a divorce, or some other situation that impacts your available income. If this is the case and you’re now struggling to pay your auto loan on time every month, don’t worry — there are several ways you can avoid defaulting on the loan:

Trade In Your Car

If your dream car has shown to stretch your budget too thin, trading it in for a less-expensive one is a good way to lower your monthly payment. Just keep in mind that you may end up with negative equity and owe more on your auto loan than the trade-in vehicle is worth.

Sell Your Car

If you don’t need the car you financed, you may be able to sell it to pay off the loan and avoid default and damage to your credit. Many dealerships are willing to purchase cars that meet their resale criteria — if the vehicle has low mileage, is in good condition, and has records of all service and accidents the car has been through.

Refinance the Loan

Refinancing is when your lender replaces your current loan with a new one with better terms for your situation. If your car loan is stretching your money too thin, your lender may be able to lengthen the term so your monthly payments are lower — although this will raise the total interest you pay over time.

Defer a Payment

In times of temporary financial turmoil, some lenders may allow you to defer paying on your auto loan for a few months without defaulting. Interest will continue to accrue during this time, but it will at least allow you to catch up financially until you’re back in a stable position. Many financial institutions also offer “skip-a-payment” programs during the holiday season to free up their borrowers’ incomes for holiday gifts.

Obtain Credit Counseling

When you feel like you’re out of options and your auto loan is becoming too much to manage, you’re not alone. The job of a credit counselor is to help you develop a plan tailored to your life and finances. Seek one out who can help you negotiate with your lender, find room in your budget to cut back, and identify other debt management solutions, including educational resources that will empower you to make better choices with your money moving forward.

Dick Says Yes Auto Credit Experts

Did you know Dick Hannah Dealerships is the No. 1 specialist in bad credit car loans? If you’re struggling to get into a vehicle because of your credit score, we can help you get approved for financing, sell your car, and more. Get in touch today!