Can an auto loan increase my credit score?
What makes up a FICO credit score
- Payment history: 35 percent
- Amounts owed: 30 percent
- Length of credit history: 15 percent
- New credit: 10 percent
- Credit mix: 10 percent
When it comes to credit scores, loans are a double-edged sword. Debt does not hurt your credit score in and of itself, but what type of loan you take out and when impacts how your score is calculated.
An auto loan can both increase and decrease your credit score, depending on your credit history and repayment behavior. Before further investigating how an auto loan influences your credit, however, consider why you are asking the question in the first place. You should only finance a car because you need the vehicle — not as a means of improving your credit. If your primary objective is improving your credit score, there are less risky strategies that do not involve taking on new debt.
Understanding credit scores
Auto loans are reported to the three credit bureaus: Equifax, Experian and TransUnion. A credit report is not a score but a list of information. You have a credit report from each agency that details your credit accounts and reported repayment behavior.
Credit scores are calculated based on the information in your credit report. There are different credit scoring companies that use algorithms to evaluate your credit report and generate a score. The most common of these is the FICO score.
FICO weighs different elements of your credit history and repayment behavior to generate a FICO credit score. Payment history accounts for 35 percent of the score; amount owed is 30 percent; length of credit history 15 percent; and new credit accounts and credit mix are 10 percent each.
Examining how a new auto loan affects each of these categories illustrates how it can influence your credit score.
Shopping for and closing a new auto loan can initially drop your credit score a few points. Scoring companies view new loans as potentially risky, particularly if several new credit accounts are opened within a short period of time.
Scoring companies know that lenders make hard credit inquiries when evaluating borrowers for loans. If the inquiries are made for the same loan type within a period of about two weeks, they are treated as a single inquiry.
If you do not open other credit accounts and begin steady repayment of the auto loan, your credit score should not be negatively impacted.
There are two primary types of credit: a revolving loan such as a credit card, and an installment loan with a fixed amount and repayment schedule. An auto loan is an installment loan.
Scoring companies consider a balance of credit types to be financially healthy. If you have a mortgage, student loans and a couple of personal loans, adding a new installment loan could hurt your credit score. If, however, you have a few credit cards but no installment loans, adding an auto loan to your credit mix can improve your score.
Older credit accounts improve your score because they demonstrate your ability to consistently maintain and pay off debt. A new auto loan initially weakens this element of your credit picture, but as you repay the loan over time, it strengthens your score.
Your credit utilization — the ratio of debt to total available credit — has a major influence on your credit score. An auto loan could initially hurt your score by increasing how much you owe relative to your total available credit. As you pay down your auto loan balance over time, however, your amount owed falls relative to your total credit, improving your credit score.
Payment history has a powerful impact on your credit score. Although it is a slow and steady process, this is where an auto loan can increase — or damage — your credit the most. Making consistent, on-time payments over the course of your auto loan are positive steps to improving your credit score. Miss just one payment, however, and your credit score can fall dramatically and stay low for quite a while. If possible, make larger monthly payments than you need to on your auto loan and pay them on time, if not earlier.