Car loans and credit scores: What you need to know

Most people know they'll need a good credit score to get a loan to buy a car. But they don't often think about how that loan will affect their credit score after they buy the car. There are a variety of factors that can affect how a car loan will impact your credit. Miss a payment and your credit score will take a hit, but consistently making payments on time will help build your credit history. Here are a few things to keep in mind:

Applying for a car loan: Know your score

When applying for a car loan, it's important to understand the basic anatomy of a credit score, where the credit score fits into the loan process and what different inquiries can be made into your credit.

First, let's look at what makes up a credit score. The FICO® credit score — the most widely used model — calculates scores on a scale from 300 to 850 points, although some older versions have a different range. The credit score is a mix of five key factors: payment history, amounts owed, new credit, mix of credit and length of credit history. Payment history is the most important influence in your credit score, accounting for 35% of the entire score. That's why paying bills and loan payments on time can be a good way to increase your credit score.

VantageScore® is another credit scoring system. It uses the same number range as FICO.

The federal government requires the three major credit reporting bureaus — Equifax®, Experian® and TransUnion® — to provide a free credit report to consumers once a year. You can get your credit report at www.annualcreditreport.com Opens in a New Window.‍ ‍ ^{See note 1} While that credit report won't include your credit score, some credit card companies offer a free version of your credit score, but keep in mind there are numerous different credit scores, so the one you see may not be the same one used for underwriting new credit applications.

Inquiries into a person's credit can also affect their credit score. There are hard and soft inquiries. A hard inquiry appears when you allow someone to look at your credit history, not just your credit score, to process a loan or credit application, like a car loan. These inquiries can affect your credit score. A soft inquiry occurs, for example, when you check your own credit report, but it doesn't affect your credit score.

How will a car loan impact my credit score?

After you take out a car loan, the quickest change you might see in your credit score is a drop. But don't panic — your car loan may help you raise your credit score.

An auto loan is commonly reported as an installment account — you're borrowing a set amount at one time and making set repayments in installments over a fixed period. Other examples of these loans include a mortgage and some personal loans.

Because payment history has the biggest influence on credit scores, installment loans are usually a good way to raise a credit score — if you make payments on time.

Another way your credit score could increase is if the car loan helps with your credit mix. The credit mix is the variety of accounts in your credit report, including installment accounts and revolving accounts. Credit cards fall into the revolving account category. If you have mostly revolving accounts, adding an installment account like a car loan may help bump up your credit score. In addition, as you pay down the loan balance over time, it could help the amounts owed category of your credit score, which is the second-highest factor in the FICO models.

Overall, a car loan, if paid on time and as an addition to your credit mix, could raise a credit score. Keep in mind that it's more of a long-term credit strategy and shouldn't be considered as a quick way to raise your credit score.

How much will a car loan drop my credit score?

Applying for an auto loan means lenders will check your credit report. As stated earlier, these hard inquiries can cause a slight dip, which can vary by person, and falls under the new credit category, which accounts for 10% of your overall FICO credit score. If your credit score is between the categories of good and excellent or fair and bad, that could have an impact on other loan applications.

If multiple lenders are making credit report inquiries over 14-45 days, these may be grouped into one hard inquiry. The time period varies depending on which version of FICO credit score is being used by the lenders.

You'll also impact the amounts owed category, which accounts for 30% of your overall FICO credit score, as you'll owe 100% of the initial loan balance until payments begin. Keep in mind, the initial loan balance reported to the credit bureaus does not take into account any down payment you may have made, only the amount borrowed.

Just like a good payment history on an installment loan can increase a credit score over time, missing a payment or payments can have an impact as well, likely lowering your credit score.

And if your car loan adds too many installment loans to your credit mix, that too may cause the credit score to lower. This is why knowing what's in your credit report is helpful.

Does paying off a car loan help or hurt my credit score?

As with many questions about credit scores, there's not a clear-cut yes or no answer.

First, regardless of credit score, you'll want to make sure your lender doesn't have a penalty for prepayment or paying off a loan early. You don't want to pay extra fees just because you can repay the loan earlier than anticipated.

When determining if paying off a loan will help your credit score, you have to consider your credit history, credit mix and payment history.

Let's start with credit history. If you're trying to improve your credit and lengthen your credit history, then making payments could help your credit score. Paying off the loan means it's no longer actively contributing to a mix of credit or amounts owed, but positive payment history will remain on your credit report for up to 10 years from the last date of activity.

If the auto loan is your only installment loan, paying it off early could lower your credit score because your credit mix will not be as varied. People with better credit scores are often those who are making payments on time on both installment loans and revolving accounts. But you have to weigh the amount you'll spend in interest, especially if it's a high-interest loan when deciding to pay off a loan early. Your credit score could also drop if the loan was your account with the lowest balance.

Overall, for consumers who may be concerned about how an auto loan could affect their credit score, they need to first get their most recent credit report. Once you know what's in your credit report, figure out your credit mix. And remember, even if your credit score takes a small hit, installment loans when paid on time can be a good way of building your credit history and raising your credit score in the future.