Each of the three major credit reporting agencies has a slightly different method for determining your credit score. According to Fair Isaac, however, your FICO score is the score that 90 percent of lenders use to help determine if they should loan money to you and at what interest rate. If you buy a new vehicle and take out a loan to pay for it, adding the loan to your credit portfolio can potentially reduce your FICO score in the short term, but it should improve your score in the long term.
Your FICO score has five importance-weighted categories. Payment history is weighted 35 percent and considers whether you make your payments on time. Amounts owed has a 30 percent weight and refers to the total amount of money you owe creditors. The age of each credit account and your credit history carries a 15 percent weight. New credit is weighted 10 percent and covers new accounts you've opened or recent inquiries into your credit report. The mix of credit you have, such as credit cards and loans, makes up the remaining 10 percent.
If you take out a loan to buy a car, it can potentially have a negative impact on each of the FICO categories except payment history in the short term. The loan increases the amount you owe creditors, adds a new account to your credit profile and potentially adds a new type of credit to your portfolio. It might have a negligible impact, a large impact or no impact at all. The extent to which it affects your score is different for each person and hard to predict, because it's based on the collective assessment of your accounts.
While an auto loan can potentially lower your credit score in the short term, it should help raise your credit score in the long term if you make your payments on time. Paying your bills on time is the single most important thing you can do to raise your credit score. Arrange for your payment to be automatically deducted from your checking account right after you get paid to ensure that you're never late on a car payment and that the funds are available when it's time to make your payment.
Credit Scores and Interest Rates
It's probably more important to have a high credit score before you take out an auto loan than after you secure the loan. A higher credit score can enable you to get a lower interest rate, which could save you hundreds or even thousands of dollars on your loan payments. You can usually save money on auto insurance premiums, too, when you have a high credit score. Try to raise your score by paying down debt, correcting errors on your credit report and bringing past-due accounts current before you secure your auto loan to get the best interest rate.
Steve McDonnell's experience running businesses and launching companies complements his technical expertise in information, technology and human resources. He earned a degree in computer science from Dartmouth College, served on the WorldatWork editorial board, blogged for the Spotfire Business Intelligence blog and has published books and book chapters for International Human Resource Information Management and Westlaw.