If you’re trying to improve your credit score, a car loan may help, as long as you make your payments on time. Understanding how credit scores work is important in figuring out how a car loan will impact your credit score.
Factors That Determine Your Credit Scores
There are multiple credit bureaus, and each of them assign you a credit score that’s based on your financial history. While your score can vary from bureau to bureau, they all consider similar factors to calculate your score. The two factors that have the most significant effect on your credit scores are your payment history and your credit utilization.
Your payment history is a record of when you’ve paid your bills, including if you paid them on time or late, if you missed any payments and if you’ve had accounts go to collections. Pay all your bills on time and you won’t have a problem here.
Your credit utilization is the amount of debt you have compared to the amount of credit you have available. To maintain a high credit score, you need to keep your credit utilization under 20 to 30 percent of your available credit. This means that if the sum of your credit limit on all your credit cards is $10,000, you should always keep your balances below $2,000 to $3,000. Keep in mind that the credit bureaus could check your credit utilization at any time, so if you pay for a large purchase on your credit card, it’s smart to pay it off as soon as possible.
While your loan debt is also considered part of your credit utilization, credit bureaus don’t weigh it as heavily as your credit card debt.
Other influences on your credit score include how long you’ve had accounts open, if you’ve made any recent credit applications, and how many types of credit you have. These are all less important factors than the two listed above.
How a Car Loan Helps Your Credit
There are several ways that a car loan can improve your credit score. The first and most important is that if you make your loan payments on time, it’s good for your payment history. When you pay down your car loan, you’ll be lowering your credit utilization, provided you don’t just make your loan payment with your credit card and then carry the balance on the card. If you’re able to pay your credit card balance every month, it’s smart to use it to pay your car loan, because you’ll be able to earn reward points or cashback and get a return on your spending.
A car loan is an installment loan, and if you previously only had credit cards, it diversifies the type of credit you have, which can boost your score. Since car loans usually have terms between three and five years, it gives you the opportunity to build up a long account history.
Why does having different types of credit help your score? With installment loans, you must pay a fixed amount every month, and the interest charges are already factored in to the loan payments from the beginning. By paying an installment loan back, it demonstrates to credit bureaus that you’re financially responsible and can handle different types of credit.
Paying Off Your Car Loan Early
If you have enough money to make larger payments and pay off your car loan faster, you may be wondering if it’s a wise decision. After all, once you pay off the loan, you won’t have an installment loan anymore, which means you have fewer types of credit. Should you just make your standard monthly payments so you pay it off on time, instead?
It’s better to pay your car loan off early if you can. Remember that the types of credit you have isn’t a major factor when it comes to your credit score, so it’s not going to make a large score difference. The sooner you pay off your car loan, the less you’re going to pay in interest. It’s always better to save on interest, as that’s just money that you’re paying to the creditor for the convenience of borrowing.
By paying off your car loan as soon as you’re able, you’ll have full ownership of the car, giving you more freedom regarding what you do with it. If you need to sell it, you don’t need to go through the complications of selling a car with an outstanding loan on it. Instead of paying interest, you can put that money into your savings or invest it.
If you’re about to apply for a car loan or you have one that you’re paying off, it can help your credit score, especially when you make your payments by the due date. But the small boost of having another type of credit doesn’t outweigh paying interest, so if you can afford to pay more on your car loan, it’s in your best interest to do so.