Almost everyone knows about good and bad debt. Mortgages are often referred to as “good” debt, while credit cards tend to be referred to as “bad” debt because of the high interest rates and large amount of fees attached.
But where do car loans come in?
Auto loans are considered consumer debt, but they’re in their own category. Your overall credit score is made up of several different sections, and about 10% of your credit score reflects the type of credit you’ve utilized. For instance, credit cards represent one type of credit usage, car loans make up another portion and mortgages round out the bunch.
The overall goal is to mix up your credit with different types of loans, so you can increase your credit history and subsequently your credit score.
Having a car loan on your report shows a new mix of credit, and can help improve your overall credit report. Additionally, if you make payments on time it shows you’re less of a risk to loan officers and banks.
A Good Measurement of Responsible Credit Usage
For some people, the progression of using credit to build a solid history for making large purchases such as buying a home begins with an auto loan. Applying for a car loan is a bit more lengthy than getting approved for a credit card (remember the free swag tables on your college campus?), and if your credit report shows evidence of on-time payments on your car loan, it will help increase your credit score.
Having a good history and no late payments shows you’re a responsible borrower and someone who could pay a future mortgage fairly easy. (Even one late payment can hurt your score)
If you have any problem paying your auto loan and your car gets repossessed, that will be an indication to banks that you will struggle to make larger payments for something like a mortgage, and it will make your credit score go down.
A car loan is often a step in the process for proving your credit worthiness, so make sure you’re ready to take on that responsibility before you make the leap. Much like the housing market, the automotive industry has been all over the place, and many people have been caught with cars that are worth less than the amount they owe on the loan. Taking out a car loan is risky if there’s any chance you won’t be able to pay, even in the event of an accident or other emergency.
What’s A “Hard Inquiry”?
Like any refinance, a car loan refinance could potentially save you money by lowering your interest rate (be sure to read the fine print on those offers of 0% interest!).
A hard inquiry is when a financial institution or lender does a credit check to see whether or not you’d make a good candidate for the loan. Every hard inquiry will drop your score by a few points and remains on your credit report for two years. If you do “loan shopping” and get quotes from a few different lenders in a short period of time (usually 30 days) the credit bureaus will often treat this as just one hard inquiry. But if you spend 6 months looking at refinancing options, that will likely result in several hard inquiries on your credit report. For this reason, it’s a good idea to limit any applications to the same 30-day period. Multiple hard inquires can significantly decrease your credit score over time and show that you might be desperate for credit.
How Car Loans Affect Your Credit
An auto loan can be used as a good tool for proving your credit worthiness, and your ability to pay back a larger debt. But it can backfire if you can’t make the payments or get stuck with an underwater car loan in the “new every two” cycle of buying new vehicles.
Like with any other debt, it’s important to understand the risks involved before taking on that challenge, and to use it strategically towards building credit and a solid financial history.
And as always, if you’re considering a home purchase, it is best to not make any capital purchases on credit that will have an impact on your credit worthiness.
Excerpt taken from readyforzero.com.