How Getting a Car Loan Affects Your Credit Score

So you’re ready to buy a new or used car and you’ve narrowed your search to the one perfect model.  Unless you’re paying cash, your search is not quite over – you need to find financing for the car.   How you shop for this financing and the loan you ultimately get will have an effect on your credit score.

There are three main things factoring into your credit score that will be affected when getting a new auto loan: the mix of loans on your credit report, the fact that you are getting a new account and the inquiries your credit report will get as a result of your application efforts.

Mix of Credit on Your Report

Statistically, the mix of credit on your report has been shown to predict your future credit risk; consumers with the top credit scores tend to have a mix of different types of accounts.  Your mix of credit accounts for 10% of your credit score.

There are three types of accounts you can have on your credit report: installment, revolving and open.

Revolving Accounts

The best example of a revolving account is a credit card.  Revolving accounts have a credit limit and the payment varies each month depending on the balance.  You have the choice of paying the balance in full or only a portion of that balance.

Installment Accounts

These accounts have a set repayment period.  The payments are usually the same, unless the interest rate is adjustable.  Mortgages, auto loans, student loans, and home equity loans are all types of installment accounts.   Usually installment loans are secured – the secured property is forfeit if you don’t make payments.  (Of course, in the case of auto loans, the security is the car.)  However, an unsecured personal loan (signature loan) is also an installment loan.

Open Accounts

Open accounts are less common on credit reports than revolving or installment accounts.  With open accounts, the balance of the account is due in full at the end of the billing cycle.  Some kinds of American Express credit cards, some gas station cards, utilities and mobile phones are examples of open accounts.

As we’ve seen, auto loans are installment loans.  If you don’t currently have an installment loan on your credit report, adding one can help your overall credit.

Number of Inquiries on Your Credit Report

During a search for the best rates on auto loans, often your credit report is pulled multiple times.  Each time your report is pulled, an inquiry is placed on it.  Individual inquiries can drop your score by as much as 5 points apiece.   Wait a minute, you might think: does this mean that buying a new car is going to severely drop my credit score?

Studies show that people who are rate shopping are acting responsibly, so FICO has adjusted their scoring model to allow for multiple inquiries which result from comparing loan terms and costs.   FICO scores, the credit scoring model that most lenders use, do not count mortgage, auto and student loan inquiries made in the 30 days prior to credit scoring.  In this way, your score is completely unaffected by your rate shopping while you search for the best loan product.

The scoring model also looks at your credit report for mortgage, auto loan and student loan inquiries older than 30 days.  If it finds any, it groups those inquiries into just one inquiry over a set shopping period.  Depending on the version of scoring model being used, that shopping period can be between 14 and 45 days.

Note that pulling your own credit report to see where you stand will not affect your credit score (these inquires do not count towards your score).

Average Age of Account

Studies show that a person’s future financial behavior is far easier to predict when there is a lengthy credit history to analyze, and credit scoring models have placed a value on age of accounts.  Average Age of Accounts (AAoA) makes up 15% of your credit score.  AAoA is calculated as the sum of the ages of every account on your report whether open or closed, divided by the number of accounts.  The average age of your accounts is usually listed on your credit report.

While negative information can stay on your report for only 7 years, accounts remaining open can remain on your report indefinitely, potentially racking up 10, 20, 30 years or more of age.   If you do not have much credit, getting a new auto loan may drop your score due to the addition of a new account, as it drops the average age.

Note: AAoA does not just drop for new auto loans; AAoA drops for any new account added to your report.  However, the effect of a reduced AAoA can be mitigated by other factors, depending on the type of account you open.  If you open a new credit card, for instance, you will not see as much of a total drop to your score because the credit limit of the card is added to your overall utilization calculation, which makes up 30% of your score.  Raising your credit limit will always help your score.

Tips on Shopping for an Auto Loan

1. If you wait until you apply for a new car loan to find out the shape of your credit, you could potentially wind up with two inquiries: one inquiry for the first loan application and one when a lender pulls your report for the second time after you correct any errors you find. This second inquiry will most likely be outside of the allowed rate shopping window time limit, and will not be grouped with the original inquiry to be counted as one.  Don’t be blindsided by credit problems!  Pull your free credit reports from all three bureaus at annualcreditreport.com and carefully go over them before investigating loan products. Resolving errors on your credit report can take a month or more, so act before you need that car loan.   If there are errors, contact the specific credit bureau to fix them.
2. Most auto loans rates are score driven, so it may be worth your while to buy a credit score (myfico.com is recommended) to see where you stand.
3. The internet is a valuable resource and doing some homework online before you actually apply for a loan would be a great way to minimize the number of inquiries which will result from your rate shopping. Most reputable companies can give you an idea of rates based on your credit score either through their website or over the phone.
4. Concentrate your rate shopping efforts to no more than 30 days long.
5. While shopping for a new loan, don’t apply for other types of credit – applying for lots of credit at the same time can drop your score, and potentially disqualify you for that auto loan.