Negative Impacts of Auto Loans on Credit Scores
Immediate Drop in Credit Score
When you shop for rates by filling out the required paperwork and permitting the dealer or lender to run a credit check, it will be recorded as a hard inquiry on the credit report.
Hard inquiries will lower your credit score temporarily by a few points.
If you have multiple inquiries within a short period, those dropped points will make a big difference.
Other than lowering your credit score, it will also block off the best available rates and terms.
However, credit bureaus consider multiple inquiries of the same type within 30 days as a single inquiry.
An Increase in Credit Utilization
Credit Utilization, or the percentage of available credit, can contribute as much as 30% of a total credit score.
High credit utilization rates may be a warning sign to lenders about a borrower’s ability to repay.
Therefore, when financing a car and raising total credit utilization, the likelihood of negatively impacting the credit score depends on the total amount financed compared to available credit afterward.
To steer clear of the negative impact, maintain a regular monthly payment on the new loan until it is paid off in full.
It is also a good idea to not apply for any more loans until you clear off the existing loan or you will end up exhausting the limit.
A Drop in the Average Age of Your Credit Accounts
The average age of all of your credit accounts can make up as much as 15% of a credit score.
A new auto loan means there will be a slight fall in the average age of the credit accounts.
The impact is directly proportional to the total number of accounts and their duration.
For instance, you have 3 credit cards with the age of 12, 7, and 5 years each. This means the average age of accounts (AoA) is [12+7+5] =24/3= 8 years.
Now, let’s say you add a new auto loan. It will lower the average age by 2 years.
This isn’t much of an impact when you have held multiple accounts for a long time.
Still, it can be a bigger concern if you have just taken out a loan or have just one credit account.
Positive Impacts of Auto Loans on Credit Scores
You can steer clear of any negative impact by making timely payments and planning ahead.
The positive impacts of an auto loan, however, will remain throughout the loan and beyond.
Most lenders like to see a mix of credit before approving a loan.
A credit mix consists of three primary accounts:
- Open accounts (credit lines with no limit that must be paid off monthly).
- Installment accounts (mortgages, home loans, car loans that are paid monthly)
- Revolving accounts (allow borrowing up to a limit while agreeing to minimal monthly payments)
Auto loans are marked under installment accounts.
If you do not already have an installment loan, getting an auto loan can help you increase your credit score based on the fact that you make payments on time.
If you make all repayments on time, your car’s entry on the credit report will be listed as current or paid as agreed.
This will positively impact your overall credit score.
Tips to Get the Best Auto Loan
When shopping for an auto loan, do the following beforehand:
- Plan and strategize in advance given that too many back-to-back inquiries will hurt your credit score.
- Consider your existing loans. It is important to be able to fit the new installment in your budget.
- Work on improving your credit score by paying down outstanding debts.
- Check your credit report closely for discrepancies and erroneous entries and work to resolve them accordingly.
Conclusion
To sum it up, do not panic if your credit score dips by a few points when you apply for an auto loan.
It can be increased by committing to timely payments.
When authorizing lenders to check your credit, make sure to clarify the type of inquiry, and make your decision accordingly.
