Buying a Car and Your credit Score: What You Need to Know
Haggling dealerships make money off of you through excessive loan markups. Here’s what you need to know about your credit score when you buy a car.
Most car buyers do not walk into a dealership with the cash to purchase a car outright. In fact, 85 percent of new cars, and more than half of all used cars, are purchased with auto loans, according to a report from the credit agency Experian.
With some legwork upfront, or by working with the right dealership, you can land a great deal with a low interest rate and reasonable payback timeline. But far too many car buyers get sucked into lousy deals and wind end up paying thousands more than they should.
The key to landing a good loan starts with understanding how loans work. In this guide we’ll explain the basics about how your credit score can influence your future payments — and help you avoid every “gotcha” along the way — so that you can save the most money.
What are my loan options?
Broadly speaking, there are two types of auto loans.
First, there’s a direct loan, which you’d obtain yourself from a bank. This is the option that requires legwork upfront, because you have to go out and shop for loans from various banks. If the finance manager approves you, you can then go to a dealership, pick out your car, and then return to the bank to get the cash.
Second, there’s an indirect loan, which you’d obtain directly through a dealership, like us. We don’t set the terms or make the actual loan. Instead, we leverage relationships with dozens of lending partners to get you the best deal we can.
This requires work — we do the loan shopping for you — and as a result, it’s standard practice to cover the costs of those hours with a small markup to the loan. At Apple Autos, we peg at about a percent, which is less than half of the industry average. If you’re shopping elsewhere, you’ll want to be sure to ask what markup they assign to their loans, because as we explain in our New Car Buyer’s Guide, loans are one of the four ways a dealer can make money off of you.
The best thing you can do to protect yourself is to ask the finance manager about the markup they’ve assigned. Dealers aren’t required by law to reveal their markup — all they have to tell you is the term, rate, total interest, and total principal and interest. But if they’re unwilling to be transparent with you, that in and of itself should tell you something.
How do banks decide whether to loan me money?
Regardless which path you choose — direct or indirect — the bank or credit union is going to evaluate your lending potential based on “the three C’s.”
1. Collateral: This is the equity you’re putting down. It can be through a cash down payment or the trade-in value on your old car. If you’re trying to buy a $30,000 car, for instance, it will be easier if you can come up with $10,000 of your own.
2. Capacity to pay: The bank or credit union is going to look at your debt-to-income ratio, which is how your monthly take-home pay stacks up against your other payments. If the institution thinks you’re stretching yourself thin, they may decide you’re too risky. “If you’re looking for a $500 a month car payment, and you make only a few hundred dollars more — well, that’s not going to work out so good,” says Mark Drews, general manager of ECMidwest, a vehicle service contracts provider.
3. Credit: This is often the first thing lenders look at. In its most simple expression, credit is expressed in a number, your credit score, which rises or falls regularly. If you’ve never missed a mortgage, student loan, or credit card payment, then your credit score should be high. If you’ve been falling behind on those financial obligations, then you’re going to have a lower score — and therefore a harder time getting a loan. But it’s still possible.
What does my credit score really mean?
Also called a FICO score (named after the Fair Isaac Company that created it), your credit score is a number between 300 and 850.
The value is based on an algorithm that weighs heavily on your payment history and current debt. To a lesser extent, it factors in how long you’ve been borrowing money, the types of credit you currently have, and the number of new credit lines you’ve opened recently.
As a general guideline on credit scores, Experian provides these categories, with Super Prime being best and Deep Subprime being worst.
Super Prime: 781 – 850
Prime: 661 – 780
Non-Prime: 601 – 660
Subprime: 501 – 600
Deep Subprime: 300 – 500
Some auto lenders look at FICO scores that tailor specifically to the auto industry, but they function the same as these scores. The difference is they put extra emphasis on car payments.
The general rule followed among loan providers is that people with bigger numbers are better at paying back loans. For example, if all other things are equal, someone with a score below 600 is four times more likely to default than someone with a score above 700. So as a general rule, banks put higher interest rates on loans going to people with lower credit scores. They might also expect you to pay a bigger down payment.
How Does My Credit Score Affect My Car Loan?
Let’s break down these numbers into real-world dollars. As of this year, for new car purchases, the average Super Prime borrower scored a loan with a 3.2% interest rate.
Deep Subprime borrowers, on the other hand, wound up paying 14.1%.
Using a car-loan calculator, you can see how those rates stack up. For a 5-year loan on $25,000, the Deep Subprime borrower ends up paying $7,893 more than the Super Prime borrower.
So clearly, it pays to have good credit.
Surprisingly, used cars typically demand even higher rates. For the same $25,000 loan mentioned above, a Deep Subprime borrower will pay, on average, 19.8% interest when buying a used car. That works out to $39,574 over the course of the loan, or $14,574 over the car’s asking price.
What Credit Score is Needed to Buy a Car?
There’s no number that absolutely disqualifies you for a loan. Instead, there are a number of factors that wield influence over whether or not you’ll be approved, including your collateral, capacity to pay, and the amount of the loan.
For example, our finance department has seen people who hold good credit scores be denied because they were trying to borrow more money than they’d proven they could handle. Conversely, our team has successfully helped people with low credit to get a loan by convincing the lender that the buyer had outstanding circumstances.
“Just the other day I got somebody approved on a brand new vehicle loan who had a 480 (a.k.a. Deep Subprime territory),” explains Toby Hewitt of Apple Ford Lincoln Apple Valley. “He was going through a divorce that wasn’t finalized, and that was driving his score down. He had to get a co-signer, but with me calling and going over everything with the bank, we got the deal done.”
How Can I Tell if I Have Bad Credit?
By law, you can obtain free copy every year from each of the big three reporting agencies: Experian, Equifax, and TransUnion. The easiest way is to go to AnnualCreditReport.com, a site that allows you to draw all three reports at once.
Looking over that report allows you to do two things.
- You can check for any mistakes that might be hurting your credit (and dispute them, if necessary).
- You can prepare yourself for whatever conversations you may have with a lending officer.
“If your report says you were more than 30 days late on your home loan six different times, your lender is probably going to ask about that,” says Drews. “So it would it would help if you had some more information to provide.” If you were facing extenuating circumstances that are unlikely to occur again in the future, say so. “Be ready when they ask what happened.”
What your credit report won’t have is your credit score. If you’re interested in seeing that too, try looking at a recent credit card or loan statement, which sometimes print your credit score. If it’s not there, consider purchasing your score online. It costs $19.95 at MyFico.com.
How Do I Buy a Car With Bad Credit?
If you do have bad credit score, the quick answer is to get a co-signer on your loan—someone with good credit. Otherwise, you’re going to have work hard to lift your credit score.
First, start hitting your monthly payments. If you can set up automatic payments on your mortgage or student loans, do so. Stick to the minimum payment—that’s all you need to build credit—and use any extra money to pay down your credit cards.
“You don’t want to carry a balance any bigger than a third of your spending limit,” says Hewitt. “If your Visa card is approved for $10,000 and you carry a $9,500 balance, that looks bad to creditors.” Pay the balance down to about $3,000 and your credit score will go up. Do that for all your cards and you should see a marked improvement in your credit score.
THE 5 STEPS TO SECURING A GREAT LOAN
1. Conduct a Self Audit
Start by visiting AnnualCreditReport.com to examine what the three major credit-reporting agencies have on file for you. That will give you a preview of what your loan officer is going to see when he or she pulls your records.
2. Fix Whatever Negative Marks You Can
If you see mistakes, report them to both the credit agency and the bank or institution that issued the error. (Find example dispute letters here.) And if you notice that you’re close to maxing out your credit cards, start paying them down now. Remember: Loan officers like to see you carrying a balance that’s a third or less than what your credit card offers — so no more than $3,000 on a card with a $9,000 limit, for instance.
3. Decide How Much You Can Put Down
With a bigger down payment, you’re accepting more financial risk. That puts the bank in a better position, and more importantly, it gives your loan officer an incentive to reward you with a lower interest rate. So for the months leading up to your purchase, consider cutting back on expenses and diverging the savings into your future car fund.
4. Talk to a Loan Officer
This is where your self audit comes in handy: By recognizing that you’ve missed some loan payments in the past, you can show up prepared to explain the circumstances. If you have the time, you can work directly with a bank or credit union that you trust. Or you can come into the dealership and let our financial department reach out to lending institutions on your behalf.
5. Consider a Co-Signer
The fastest way to score a better interest rate is to enlist the help of a friend or family member with a good credit history. So if you’re denied a loan or simply not happy with the terms, look at the people around you. If one of them is willing to vouch for you and accept responsibility for keeping your payments on schedule, it could save you thousands of dollars over the course of your loan.