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There are two schools of thought when it comes to whether it is smart to finance a car. One says that you should live a cash-only life, which is very difficult to do, and the other is that using a car loan intelligently is very helpful in many aspects of your life, particularly your credit.

Credit Impact:  Payment History and Credit Mix

If you want to have a high credit score, financing a car is almost a must. The Fair Isaac Corporation (FICO) creates the most widely used credit scores. When a credit score is being built by FICO, thirty-five percent of the score is based on your payment history, and ten percent is built on the types of credit that you have used. Financing a car will not only establish a payment history, but also diversify the types of credit (credit mix) that you have used. To further diversify your types of credit, you can obtain a credit card.

Role of the Auto-Enhanced Credit Score

Additionally, when you apply for a car loan, lenders will request your auto-enhanced credit score from FICO. This score is always different from your basic credit score, in that it adds or deducts points based on your previous use of auto loans and leases. If you have never had a car loan, this score will be nearly the same as your basic score. If you have had an auto loan and paid it on time for at least twelve months, then this score will be higher. On the other hand, if you have made even a single late payment on a car loan or defaulted, this score will be at least 100 points lower than your baseline score.

Lower Rates in the Future

A third point about financing a car is that it can help you get lower interest rates in the future. After repaying one car loan responsibly, your credit score may be high enough to qualify you for a lower interest rate the next time you need a loan of any type. Think about it:  if lenders have seen that you are willing, capable, and likely to pay off one loan, they are going to trust that you’ll do it again the next time around. You’re less of a risk in their eyes, which translates into lower rates.

Smart Financing for the Savvy Shopper

Of course, you have to be smart about your vehicle, your loan, and your monthly payment. Biting off more than you can chew, in terms of monthly payment, could easily lead to late or missed payments, both of which will decimate your credit score in record time. Make sure your financing arrangement meets the following rules of thumb, and you’ll be well on your way to success:

  • Monthly Payment:  should be just 8% of your income, if even that much.
  • Loan Term:  should be as short as possible. A term of 36-48 months is best.
  • Down Payment:  10% for a used vehicle, 20% or a new one.

When you look at all of these points, you can see that financing a car can be a smart option, as long as you are smart in how you go about it.

 

About the author: Jerry Coffey

 

Jerry Coffey is the financial expert here at AutoFoundry.com. A recovered "debtaholic," he now preaches frugal-living and sound money management here and at Repaid.org, where he is the chief contributor. He works for a major automaker.

 

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3 Comments

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  2. Pingback: Carnival of Financial Camaraderie | Digital Personal Finance

  3. We got a car loan because it allowed us to pay off higher interest debt. My husband graduated from grad school, got a job an hour away and we live snowy buffalo with a kid, we needed a second car. We had enough money to either pay off all is student loan debt (5.75%-6.55%) or buy a car, not both. Since we were able to get a loan for 1%, and we bought used car we took the car loan and paid off the student loans. We still are going to pay off the car loan as fast as we can, but I feel happy with what we did.

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