Paying off debt early is generally a good thing. That includes car loans. But itâs worth understanding how paying off debt earlier than planned might affect your credit.
It may seem backward, but paying off a car loan early could hurt your credit. But how exactly it could affect your scores depends, in part, on your overall credit profile.
Getting a new set of wheels can be an exciting experience. But once the thrill wears off, you’re left with a hefty car payment every month. Luckily, making those payments can actually help improve your credit. Here’s exactly how paying a car loan builds your credit score.
What Does It Mean to Build Credit?
First, let’s quickly go over what it means to build credit. Your credit score is a number that tells lenders how reliable you are when it comes to repaying debts. The higher your credit score, the better your credit.
Building credit refers to taking actions that boost your credit score over time. This is important because the higher your credit score the easier it is to qualify for credit cards loans, mortgages, and other products with favorable rates and terms.
How Car Loan Payments Help Your Credit
Paying your car loan on time each month demonstrates to lenders that you’re able to responsibly manage installment debt. An installment loan like a car loan has a set repayment schedule with payments of equal amounts. This type of loan differs from revolving credit like credit cards where your payment amounts vary based on your balance.
According to FICO, payment history is the biggest factor impacting your credit score. When you make on-time payments, you build a positive track record over time. This signals to lenders that you are creditworthy and likely to repay other debts responsibly too.
In contrast, if you make late payments, get sent to collections, or default on your auto loan, it can significantly damage your credit score. Missed payments remain on your credit report for 7 years.
Beyond payment history, having a mix of credit types also influences your score. Car loans fall under the installment loan category. Maintaining installment loans along with credit cards shows lenders you can manage diverse credit types.
Other Ways a Car Loan Can Help Credit
Beyond just making payments here are a few other ways getting a car loan can build your credit
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Increases total accounts: Lenders like to see that you have some depth to your credit history with multiple accounts, including both installment loans and revolving credit.
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Lowers credit utilization: Car loans add to your total credit limit across accounts. This lowers your overall credit utilization ratio, which is the percentage of credit used versus available. Lower utilization improves credit scores.
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Length of credit history: The longer you successfully hold accounts open, the better for your credit mix. Keeping your auto loan open for many years grows your credit history.
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Chance to refinance After initially getting your loan, you may later qualify for better terms by refinancing your car. This allows you to get a lower rate thanks to the improved credit you built.
Using a Car Loan to Establish Credit
For those just starting to build credit with no prior history, getting an auto loan can be a challenge. However, there are some options for getting approved:
- Apply with a cosigner who has established credit
- Consider a “first-time buyer” program through automakers
- Look for “starter” car loan programs at credit unions
- Explore secured auto loan programs that require a deposit
As an alternative to traditional loans, you may also want to check out credit builder loans. These require regular payments just like a car loan but with lower amounts. Once completed, the lenders reports your payment history to the credit bureaus.
Tips for Maximizing Credit Building with a Car Loan
Follow these tips to get the most credit score boost from your auto loan:
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Make payments on time every month – Set up autopay or payment reminders to avoid lapses. Even one 30+ day late payment can drastically hurt your score.
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Keep loan open until fully paid – Don’t trade in or sell the car until the loan is satisfied. Keeping accounts open longer strengthens your credit mix.
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Pay extra when possible – Making larger payments reduces the interest you pay and also shortens the loan length. Just be sure to specify that extra amounts go to the principal.
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Monitor your credit – Check your credit reports and FICO score periodically to catch any reporting errors early. Use free services to monitor your credit.
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Limit hard inquiries – Each application for new credit results in a hard inquiry on your report. Too many hard inquiries in a short span can negatively impact your score.
The Bottom Line
When used strategically, an auto loan can be a valuable tool for building your credit history and improving your credit score over time. Just be sure to make all your payments on time and keep an eye on your credit along the way. Consistent, on-time payments will demonstrate to future lenders that you know how to manage credit responsibly.
Lowers your debt-to-income (DTI) ratio
Paying off your loan could decrease your DTI ratio. And a lower DTI ratio can help you qualify for other loans and better interest rates.
Your credit will be accessed in the near future
Paying off a car loan can cause your credit scores to drop temporarily. So if youâre planning on doing something soon where your credit scores will be checked, like applying for a mortgage, you might want to consider the effects on your credit scores.
How a Car Loan Affects Credit Score – Auto loans raise or lower scores? How fast? How many points?
FAQ
Does a car payment raise your credit score?
An auto loan is a type of installment loan, like most student loans, mortgage loans, and personal loans. As long as you make the monthly payment by the due date every month, a car loan should help your credit score over time. You shouldn’t buy a car or get a car loan just to build credit. Auto loans can be expensive.
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