A credit score is one of the most commonly referred to concepts in the world of personal finance - and for good reason! Your credit score has the capacity to influence financial aspects of your life, such as whether you can take out a loan or purchase a home.
If your credit isn’t the greatest, you may have already experienced challenges achieving your financial goals. The good news is, poor credit is never forever, so long as you put in some work. One way you could improve your credit is by obtaining and responsibly managing a car loan. You might be wondering, how can taking out more debt make my financial situation better? To find out the answer to that question, continue reading below.
How Your Credit Score is Calculated
You might know what your three magic credit score digits are, but how exactly was that number calculated? Your credit score is calculated using six factors, all with varying weights, which will be discussed below. Knowing what goes into your credit score will help you understand what you can do to improve it.
- Payment History (35%): This factor makes up most of your credit score, it is definitely an important one to consider. Full and on-time payments will ensure you score well in this category.
- Credit Utilization (30%): Under this category, how much of your credit you are currently using compared to what is available to you is considered. The lower your credit utilization ratio is, the better. The reason it’s a bad financial habit to have your credit cards constantly maxed out is because of this factor.
- Length of Credit History (15%): How long you’ve been using and managing credit is considered here. The idea is that the longer your credit history is, the more accurately someone can assess your creditworthiness because there is more information to draw from.
- New Loans or Applications (10%): Whenever your credit report is pulled, an inquiry is recorded which brings down your credit score slightly. Generally, a high number of inquiries is seen as a negative because it indicates the individual is struggling financially and therefore is desperately seeking financing.
- Credit Mix (10%): This category considers the different types of debt an individual is currently managing. A person with a diverse portfolio is seen to be good at managing debt overall when it comes to calculating your credit score.
- Public records/derogatory marks – Bankruptcies and derogatory marks can have a series impact on your credit score.
When it comes to car loans and improving credit, you can hone in on three of these factors: payment history, length of credit history and credit mix. Car loans will not improve your credit in relation to the other three factors. A car loan is an instalment loan which means that it’s not revolving and therefore won’t contribute to your credit utilization ratio. Also, when you apply for a new car loan, it will temporarily reduce your credit score since it is a new application. But, as the old saying goes, sometimes you need to give a little to get a little!
How a Car Loan Could Improve Credit
As mentioned, there are three areas of your credit score that can be improved using a car loan. Let’s explore these in-depth below along with a few other benefits.
- On-Time, Full Payments. Car loans require regular payments on a set date over a specific period of time. If you manage to make them on-time and in full every payment date, your credit score will improve. It’s all about responsibility and dedication.
- Credit History Growth. As you make payments towards your car loan, your credit history will grow which will improve your credit score.
- Credit Mix. If you don’t already have a car loan or other type of instalment loan, getting a car loan will diversify the type of debt you manage. Keep in mind that you should only get a car loan if you can afford one. Getting one purely to diversify your credit mix will only hurt you in the long run as you might struggle with payments.
- Improve Financial Habits. Taking on debt can help individuals become more mindful of their financial decisions and stimulate change. Better financial habits will help you improve credit and make your financial situation more sustainable.
- Cars Are Useful for More Than Building Credit. A car is a very useful asset to have. It can get you to work, take you on all your errands and drive you to your next hang out with a friend.
Wouldn’t it be nice if everything only had benefits and no drawbacks? It certainly would be, but sadly that almost never happens in personal finance! Below are some negative aspects to consider before using a car loan to improve your credit.
- Unfavourable Terms Initially. If you have poor credit now, chances are you won’t get the best interest rates and other terms. While this is a sacrifice initially, you can always refinance in the future to get the terms you want after you’ve spent some time building credit.
- Car Loans Don’t Improve Financial Habits, You Do. Managing a car loan can help you improve your financial habits, but the car loan won’t do that on its own. If you have poor credit, it’s likely that your financial habits aren’t the best. Changing financial habits takes time and work, if you’re not ready for the commitment, you could get yourself into a worse situation.
- Additional Costs of a Car. Cars are not a cheap asset to own, they come with repairs and maintenance costs on top of the financing and insurance expenditures. Consider all the costs of owning a car before making your final decision.
The Bottom Line
All in all, using a car loan to build credit is an effective strategy, so long as you manage the loan responsibly and have the means to do so. Before jumping into your purchase, remember to consider your budget, financial goals and current position. Remember, merely obtaining a car loan won’t fix your credit, you’ll have to put in work. That being said, if you’re ready for the commitment and have the funds available, start driving up your credit score with a car loan today.