How to use a car loan to rebuild your credit.
How many life events or goals in your life require credit? For most, the two top of mind answers would be a car and home ownership. If you’re rebuilding your credit and/or trying to make up for past credit misgivings, these two goals may seem completely out of reach. And, because of this, you may think, the logical starting point is a getting a secured credit card or another very minor move towards becoming creditworthy again.
Although you may be right, it certainly doesn’t make sense to take on added debt you can’t afford. But, if you have income that allows it, a car loan can provide unique opportunity to enable you to rebuild your credit rating and get back on track.
Explained – Installment Credit VS. Revolving credit
By understanding how credit agencies look at the two primary types of credit, it will help you understand the potential value of a car loan.
Revolving credit, for the most part, refers to credit cards. They call it revolving credit because the monthly balances and minimum monthly payments rise and fall cyclically. Think about it, just because your credit card bill was $250 this month doesn’t mean it will be half that or double that amount the next. Nor with a credit card are you required to pay the exact, full balance. Credit card companies will place a minimum payment which may be just $25. You may also elect to pay the entire bill to avoid any interest and finance charges.
For lender (banks and finance companies), this flexibility seems less applicable for securing financing for an automobile or a home, which are considered installment loans. With an installment loan, you would borrow a set or fixed amount, with set payment and no flexibility to borrow more money or pay less of the payment each month. Because of this, installment loans can also be referred to as “closed-end” accounts.
Also, in most cases, installment loans typically are for larger amounts than you would see with revolving credit. This means you may be able to rebuild your credit much faster with an installment loan. Think of it this way, A $35,000 car loan can establish your capacity to manage $35,000 worth of credit in as little as year or two, compared to a slow-and-steady accumulation of credit over time through low-limit credit cards. If owning a home is your ultimate credit goal, a car loan provides the parallel framework for a home loan.
Most credit reporting agencies (Equifax, Transunion, Experian) reward borrowers for managing multiple types of credit at once including a mix of revolving and installment loans. Additionally, credit agencies will value active loans much higher than closed loans. Indeed, successfully completed loans will bode well for your credit worthiness, but lenders are most interested in how risky it is to extend credit (lend money) to you right now! It is for this same reason, that older credit mistakes matter far less than more recent ones.)
How to make sure your car loan will rebuild your credit
Make an assessment of your financial situation
Making use of a car loan to rebuild your credit is a sound financial decision (if you can afford the car). If you are already maxed out and don’t think you can afford to take on more debts, getting a car loan might not be the answer. Instead, maybe you should look at a consolidation loan where you can take all of your outstanding payments and blend them into a car loan giving you a more manageable payment at a fixed interest rate. If you are just at the limit of what you can hadle based on how much you arebringin in verses how much you are paying out the focus on paying down your existing debts until you have cleared up enough that you can afford a car. Otherwise, you may, in turn, end up making car payments only to fall behind on credit card debt further adding to the situation or making the situation worse. At best, that’s a zero-sum game for your financial well-being and future credit needs.
If you have decided you are financially ready to take on a car loan (and perhaps adding revolving line of credit, as well), don’t open multiple new accounts at once. Most credit agencies will see three or more active credit accounts as enough to show a diverse credit stream. Going on a spree of opening and or apply for multiple credit products at once or within a short period can be a warning flag to credit agencies, They can interpret these as the actions of someone far too eager to expand their access to credit. It could even be viewed as reckless.
Make sure you choose the right vehicle
If you are only just starting to rebuild your credit and money is still tight, it may not be time yet to go all out on your dream car just yet. Remember this is a marathon, not a sprint. Besides, regular payments on a used car will get reported each month or two just as they do on a new vehicle. But be aware that some dealerships that advertise “Buy Here Pay Here” car programs will not report your payments to the credit bureaus—you have to make sure your dealer reports payments so that you will benefit from the car loan in rebuilding your credit)
One of the main reasons that car loans are more accessible for many with less than stellar credit is that dealerships benefit from selling cars. A dealership may be willing to take on slightly more risk than traditional banks, which aren’t in the car business and receive no benefit from a car moving off a dealer lot. Auto Dealers also work with many lenders and pool their customers increasing the chances of finding a lender who not only will approve a car loan for you but will approve it with an interest rate you can afford which in most cases will be a lot less than what your bank would approve you for.
As you are rebuilding your credit, it is important to remember that you’re unlikely to get the best offered rates from a lender, initially. This is simply because you represent higher risk. If you want to help reduce the financial burden of higher interest rates, consider coming up with a down payment. While not essential having a down payment can help with loan approval and your ability to pay back the loan.
Super Obvious one, Make your payments on time
Once you’ve secured an auto loan, absolutely nothing is more important than making on-time payments. This is the cornerstone of being credit worthy. Consistent, on-time payments are without a doubt the best way to reinforce your creditworthiness and help build your credit score. If you aren’t great with remembering this thing you can ensure on-time payments by setting up an automatic withdrawal through your bank account. For one, you’ll save time and stress, and you’ll also guarantee that you’ll never miss a payment.
Even as little as six months, a consistent history of on-time auto loan payments can begin to show progress with your credit score. While it may seem tempting if you have the means to pay off your car loan early each month you make an on-time payment it is a valuable addition to your credit file. Which may be more valuable than the additional interest you are paying on maintaining the loan.
If you have a 48-month loan which you pay off in 8 months, it doesn’t provide history very much to credit bureaus. Of course, you’ll save on interest payments by paying the loan off your loan early. But you have to remember that it is a balancing act based on your financial situation and the need to build up credit with your auto loan. It’s a tool to rebuild and reestablish yourself.
If you have thought about it, and have decided to pay off your loan early, make sure there are no prepayment penalties included in your loan documentation. Keep in mind that part of the evaluation of your credit is how much of your available credit you are using. Case and point, if you pay off the outstanding $15,000 on your car loan, you will reduce your total debt by $15,000, but, by closing out the loan, you will also drop your total credit available by the original amount of the auto loan. (Say $35,000) This can quickly push your credit utilization rate much higher causing your credit score to drop.
If you’re wondering whether you would qualify, or would like to get some advice on things unique to your financial situation, just contact us, or fill out our online credit application.