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How Does Getting an Auto Loan Affect Your Credit Score?
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Opening any type of loan, including an auto loan, will typically result in a slight dip in your credit score. But know that it’s only temporary and as you make payments in a timely manner, your credit score should recover quickly.
However, it’s important to understand why your score drops if you get a new car loan and know that there’s no reason to panic.
How applying for a new auto loan will impact your credit score
When you visit a dealer and decide to purchase a car, fill out the loan paperwork and give the dealer permission to run a credit check, that generates a hard inquiry on your credit report. Hard inquiries will reduce your credit score anywhere from 5-10 points for about a year.
If your credit score is on the border between “good” and “excellent” (or “fair” and “bad”), those points could make a difference. That’s why you may not want to shop for a new car and a new home within the same year because multiple hard inquiries could drop your credit score to a lower tier and you could miss out on the best rates.
Fortunately, the credit bureaus understand that people may want to comparison shop for a car or home loan. If you have multiple inquiries of the same type within a 14- to 45-day timespan, the credit bureaus consider it a single inquiry.
Hard inquiries should not be confused with “soft” inquiries. Soft inquiries occur when a lender reviews your credit report for marketing purposes or when you check your own credit reports and scores, and they are only visible to you when you pull your credit report and don’t negatively impact your credit score.
A new auto loan may lower the average age of all your accounts
The length of your credit history and the average age of your accounts make up 15% of your FICO score.
When you open a new loan or credit card, the average age of your accounts will fall slightly. If you have multiple accounts for decades, the hit will be very slight. But if you only have one or two accounts, it could have a bigger impact.
For instance, let’s say you’ve held two credit cards for 20 years, and three others for 18, 16, and 15 years. You also took out a mortgage 17 years ago. The average age of your accounts is 17.6 years (20+20+18+16+15+17 divided by 6 accounts). When you open a new car loan, that average will drop to about 15 years – still well over a decade.
But if you’re new to credit and only have two credit cards that you opened a year ago, and you get an auto loan, the average length of your accounts drops in half, from one year to six months.
An auto loan will NOT impact your credit utilization
Credit utilization is the amount of revolving debt (think credit cards or home equity lines of credit) you’re carrying on a monthly basis relative to your credit limits. For example, if you have a credit card with a credit limit of $5,000 and your balance is $2,500, your credit utilization is 50%. Experts recommend keeping your utilization well below 30% to protect your credit score.
The good news is that only revolving credit accounts, such as credit cards, impact credit utilization, which accounts for 30% of your credit score. Loans, including auto loans, are not calculated into credit utilization and, therefore, will not impact this scoring factor.
How an auto loan can help your credit score
Fortunately, any temporary hits to your credit score will vanish as time passes. But the positive effects will last for the length of the loan, as long as you continue making on-time payments.
A new auto loan can also help improve your credit mix, which comprises 10% of your credit score. For example, lenders want to see that you can manage different types of credit responsibly when they consider giving you a new loan. There are three main types of accounts you can have:
Revolving accounts, like credit cards, as well as home equity lines of credit, allow you to borrow money up to a certain limit and make monthly payments.
Installment loans, including mortgages, car loans and personal loans, are paid off in equal installments over time. Unlike revolving credit, you no longer have access to that credit as the loan is paid down.
Finally, open accounts are lines of credit with no limit, which must be paid off at the end of every month, such as American Express charge cards.
Adding an auto loan can help improve your credit mix, provided you make on-time payments and manage the loan responsibly.
Tips for shopping for an auto loan
If you’re ready to make the leap and join the 44% of Americans with an auto loan, follow these steps to find the best interest rates:
Prep your credit
Buying a new vehicle shouldn’t be rushed. As you start researching your dream vehicle, it’s time to also make sure your credit is in tip-top shape.
First, get copies of your credit report from all three major U.S. credit bureaus: Equifax, Experian and TransUnion for free from annualcreditreport.com. If you find any mistakes on the report, contact the bureau that provided it and file a dispute.
Don’t apply for any other new credit in the days and weeks before you apply for a car loan. You don’t want to risk lowering your credit score because it could mean paying higher interest rates.
Consider third-party financing
If you are buying a new or certified pre-owned vehicle from a dealer, it may be tempting to obtain an auto loan through the car dealer. After all, dealers entice you to apply for financing immediately with promises that you can “sign and drive,” without additional trips to a bank or more paperwork to file.
But unless you have excellent credit and qualify for 0% financing through the dealer, it’s wise to explore your auto loan options.
Smart borrowers will instead look at banks or credit unions to get financing. Banks reported $368 billion in open car loans in 2017, ahead of credit unions ($313 billion), and dealers, otherwise known as “captive auto companies” ($259 billion).
Know how much you can afford
While you want to negotiate with the car dealer based on the sticker price of the vehicle, it’s important to know how much of a car payment you can actually afford before you apply for an auto loan.
Factors like the interest rate you qualify for, the length of the loan, your down payment and even the amount you’ll get for trading in an older vehicle can all affect your monthly payment.
Our auto loan calculator can help you determine how much you’ll pay out of pocket and your monthly payments before you apply for an auto loan so you’ll know what to expect.
Make your auto loan payments and watch your score rise
In sum, don’t be upset if your FICO score takes a hit after you close on your auto loan. Make your payments on time every month and you could see your score reach new heights. In the meantime, enjoy your new ride.