Ready to buy a car?
A car may be one of the most expensive purchases you’ll ever make – second only to a home. The average car price is $36,000, according to Kelley Blue Book. That’s a whole lotta dough.
While you can certainly save money by buying a used car, you will still need to come up with enough cash to drive away in your new wheels. If you don’t have the money on hand, your other option is to get a car loan.
Car loans can certainly help you buy a car, but in order to get approved for a loan, you’ll generally need a good credit score and money in the bank for a downpayment. Read on to learn more about car loans and how your credit score can help you buy a car.
How Do Car Loans Work?
Car loans are similar to other types of loans. You usually have to come up with a down payment and you can then apply to borrow the rest. You can get a car loan at an auto dealership, or at a bank or credit union. There are also some online lenders that specialize in car loans.
Some car dealerships will allow you to trade in your current car and use the value as a down payment for the new car. They will then run your credit and shop around for the best lender for your loan. This can take some time which is why it’s not uncommon to spend several hours at the car lot as you wait for a financing decision.
Once you have been approved for a car loan – either at a dealership or through another lender – you can review loan terms and sign paperwork. You’ll be given an interest rate based on your credit score, income, and debt-to-income ratio (how much you already pay toward your debt each month compared to how much income you bring in.)
Generally, you’ll be asked what your budget is for a monthly car payment. Lenders can shorten or lengthen your loan repayment term based on this preference. For example, you can get a 36-month car loan or even a loan that will take you seven years to pay off. The longer the loan, the more interest you’ll typically pay over time.
What Type of Credit Do You Need?
Your credit score is the number one factor that will determine whether you get approved for a car loan or not.
Of course, if your credit score is excellent or above average, you can rest assured that you’ll likely get a loan with the best terms. If you have no credit whatsoever, you probably won’t be approved for a car loan and it’s time for you to build your credit.
Each quarter, Experian publishes a report detailing the state of the automotive finance market. This is how Experian, as well as most lenders, rank borrowers’ credit scores:
Super Prime: 781 – 850
Prime: 661 – 780
Nonprime: 601 – 660
Subprime: 501 – 600
Deep Subprime: 300 – 500
If you have super prime credit, meaning your score is excellent, you can expect a low interest rate around 2.6% for a new car and 3.4% for a used car. With nonprime credit or an average score, you can expect a rate around 6.39% for a new car and 9.47% for a used car.
With deep subprime credit, which are the lowest scores, you may not get approved for a loan at all. If you do, your interest rate will be the highest, averaging around 13.3% for a new car and 18.9% for a used car, according to Bankrate.
Clearly, having a higher credit score will get you the best terms and the lowest interest rates. And this can save you a ton of money as you repay your loan. If your credit score is subprime or worse, it’s probably a better idea to work on building your credit before applying for a car loan.
Getting Your Credit Ready For a Car Loan
If you want to build your credit score or improve it, you first need to understand how credit works. Lenders look at your FICO score when considering whether to approve your car loan application. FICO is a specific credit scoring model, but it helps to understand how it works so you’ll know which areas of your credit report to focus on.
According to MyFico, credit scores are calculated by using these five main factors:
Payment History – 35%
Amounts Owed (overall utilization of your credit limits) – 30%
Length of Credit History – 15%
Credit Mix – 10%
New Credit – 10%
As you can see, your payment history and amounts owed hold significant weight in terms of determining your score. If your score is low, odds are your payment history is not good.
So, how long does it take to improve your credit? Depending on how much work you need to do, some experts state that you can improve your credit in as little as a few weeks on up to 18 months. To start making improvements, you can do the following:
- Try monitoring your credit and tracking your improvement by using free sites like CreditKarma and CreditSesame.
- Use your credit cards wisely, which includes paying off some debt to lower your balances.
- If you see missed payments or defaults on your credit report, contact the lenders to find out if you can settle the balance.
- If you have no payment history whatsoever, consider getting a secured credit card and putting a small monthly charge on it. Then, pay it off in full each month to build some positive payment history.
- Keep your credit utilization under 30%. This means that if you have a credit card with a $2,000 limit, for example, you shouldn’t carry a balance of more than $600. Going above and beyond that amount tells lenders that you can’t control your spending and rely on credit too much. If you aren’t making consistent payments on your balance on top of that, this makes you look like a risky borrower.
Temporary Alternatives to Financing a Car
If you have bad credit or no credit at all, now is a good time to try transportation alternatives to buying a car. For example, while working on building your credit, you can give public transportation or carpooling a whirl.
Or, you can try buying an older used car with cash just to get you from one place to another. You can use windfalls like a tax refund or bonus payments from your job to help you round up the money to buy a cheap car. This might hold you over until you can beef up your credit score and apply for a car loan for a new car.
Working for a Better Credit Score is Worth It
Don’t lose hope or patience if your credit score needs to be improved before you finance a car. The benefits of working your way up to an excellent credit score will be well worth it when you get a car loan with the better terms and a lower interest rate.
Remember: A lower interest rate for your car loan will potentially save you thousands of dollars. Are you ready to start building your credit?
This page is for informational purposes only. Chime does not provide financial, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal or accounting advice. You should consult your own financial, legal and accounting advisors before engaging in any transaction.