How can a car loan help rebuild my credit?

Which goals in your life require access to credit? For most, two quick answers are car and home ownership. But if you’re rebuilding credit and trying to atone for past credit mistakes, those two goals may seem far off. And, you may think, the logical starting point is a secured credit card or other minor move toward credit worthiness.

You may be right. Certainly, it doesn’t make sense to take on added debt you can’t afford. But, if your income allows, a car loan can provide unique value to help you rebuild your credit and achieve your goals.

Revolving vs. installment credit

Understanding the potential value of a car loan requires understanding how credit agencies view the two main types of credit: revolving and installment. Both play a role in your credit report.

Revolving credit, most often, refers to credit cards. It’s called revolving credit because monthly balances and payments rise and fall cyclically. Just because your credit card bill was $250 this month doesn’t mean it will be half that or twice that the next. Nor are you required to pay the exact, full balance. A minimum payment may be just $25, but you may also decide to pay the entire bill to avoid finance charges.

For credit agencies, this flexibility seems less applicable for securing financing for a car or home, which are installment loans. With an installment loan, you borrow a fixed amount, with set payments and no ability to borrow more or pay less each month. Because of this, installment loans are sometimes called “closed-end” accounts.

Also, installment loans usually are for larger amounts than revolving credit. This means you may be able to build your credit faster with an installment loan. A $25,000 car loan can establish your capacity to manage $25,000 worth of credit in just a year or two, compared to the slow-and-steady accumulation of credit through low-limit credit card. If home ownership is your ultimate credit goal, a car loan provides a parallel framework for a home loan.

Most credit reporting agencies reward borrowers for managing multiple types of credit, including a mix of revolving and installment credit. Additionally, credit agencies value active loans more than closed loans. Certainly, a successfully completed loan bodes well for your credit worthiness, but lenders are most interested in how risky it is to lend money to you right now. (For this same reason, older credit mistakes matter less than more recent ones.)

Making sure your car loan rebuilds your credit

1. Assess your financial situation

Using a car loan to rebuild your credit is a sound financial decision—if you can afford the car. If you can’t afford to take on more debt, getting a car loan will not be the answer. Focus instead on paying down existing debts until you can afford a car. Otherwise, you may end up making car payments only to fall behind on credit card debt. At best, that’s a zero-sum game for your financial and credit future.

If you are financially ready to take on a car loan (and perhaps a revolving line of credit, too), don’t open multiple new accounts at once. Three or more active credit accounts are enough for most credit agencies to see a diverse credit stream. Opening several accounts within a short time period can be a warning flag to credit agencies, which interpret those as actions of someone too eager—perhaps even reckless—to expand their access to credit.

2. Choose the right vehicle

If your credit is only recently on the mend and money is still tight, it may not be time yet to splurge on your dream car. After all, steady payments on a used car get reported each month just as they do on a new car. (Be aware that some “Buy Here Pay Here” car sellers will not report your payments to credit bureaus—make sure your dealer reports payments so that you benefit from the car loan.)

One of the reasons that a car loan is more accessible for many with shaky credit is that dealerships benefit from selling cars, and they may be willing to take on slightly more risk than a traditional bank, which doesn’t benefit from a car moving off a dealer’s lot. Dealers also work with many lenders, increasing the chances of finding a lender who not only will approve your loan, but will approve it with an interest rate you can afford.

As you rebuild your credit, remember that you’re unlikely to get the best offered rates from a lender, simply because you represent higher risk. To help reduce the financial burden of higher interest rates, consider bringing a down payment to the table, which, while not essential, always helps with loan approval and your ability to pay back the loan.

3. Make your payments on time

Once you’ve secured your auto loan, nothing is more important than making on-time payments. Consistent, on-time payments are the best way to reinforce your credit worthiness and build your credit score. You can ensure on-time payments by setting up an automatic withdrawal through your checking account. You’ll save time and stress, and guarantee that you’ll never miss a payment.

Even within six months, a history of on-time auto loan payments can begin to show progress in your credit score. While paying off your car loan early may be an option—and seem like a good way to show responsibility—each month you make an on-time payment is a valuable addition to your credit file.

If you pay off a 36-month loan in 8 months, it doesn’t provide as much history to credit bureaus. Of course, you will save on interest payments by paying off your loan early. It’s a balancing act based on your financial situation and the need to build credit with your auto loan.

If you decide to pay off your loan early, by any amount of time, make sure there is no prepayment penalty in your loan agreement. Also, remember that part of the evaluation of your credit is how much of your available credit you’re using. For example, if you pay off the remaining $7,000 on your car loan, you reduce your total debt by $7,000, but, by closing the loan, you also drop your total available credit by the original amount of the loan, which could quickly push your credit utilization rate higher.

If you’re wondering whether you qualify, or would like to get advice on your unique financial situation, just contact us, or fill out our online credit application.