Unless you have the cash on hand to buy a new car outright, your credit scores play a significant role in determining whether you qualify for financing and, if so, how much interest you'll pay. The lender you select to finance your automotive purchase evaluates your credit scores using a tier system. Your FICO scores fall somewhere in the range of 300 to 850. In general, the higher your credit score, the higher tier you qualify for. In turn, this affects your interest rates. While the tier system is associated primarily with auto loans, other lenders also use this method to reduce risk when providing consumer financing.
The Tier System
The tier system provides lenders with a method to measure your creditworthiness and risk level by placing you into one of several categories or “tiers.” If you have credit scores that exceed 720, you pose a low risk for the lender and qualify for the first tier. Because individuals in Tier 1 have the lowest risk of default, their loans carry the lowest interest rates. If your credit scores exceed 700 but not 720, you fall into the second tier. Because your credit rating does not exceed 720, you pose a slightly higher risk of default and therefore do not qualify for the same low rates as individuals in Tier 1. This trend continues with each tier carrying slightly higher interest rates than the one above.
Tier System Differences
Although credit scores from 700 to 719 generally fall into the Tier 2 range, this is merely an average. The system your lender uses determines the tier you fall into, and not all lenders use the same system. This makes shopping around for an auto loan crucial. Credit scores that constitute Tier 2 with one lender may fall into the Tier 1 range with another. For example, if you take out an automotive loan for $30,000 and pay 7.5 percent interest under Tier 2, your interest payments over the life of the loan total $800 more than they would if you qualified for a Tier 1 interest rate of 6.5 percent.
Raising Your Scores
Taking the time to work on your credit rating before shopping for a loan can help you qualify for financing above Tier 2. While you cannot remove accurate negative information from your credit history, federal law allows you to dispute any incorrect or questionable entries on your credit report. The credit bureaus must investigate and remove any errors they find.
Negative entries adversely affect your scores. Thus, fixing the errors that are hurting your score could bump you into a higher financing tier. Keeping balances on revolving debt, such as home equity lines of credit and credit cards, low and paying your debts on time also increases your credit scores.
Car dealerships offer financing as a matter of convenience for customers, but the interest rates dealerships offer are rarely -- if ever -- lower than those offered by banks. Dealerships often charge rates up to 2 percentage points higher than the rate you actually qualify for. By keeping the additional interest you pay, the dealership makes a profit. Because of this, if your credit scores fall into the Tier 1 range, you could end up paying a Tier 2 rate. As a Tier 2 customer, your rates would be even worse. Fortunately, you can avoid paying higher interest charges by financing your vehicle with a bank or credit union. Doing so allows you to “cut out the middleman” and save money on interest charges -- even if you don't qualify for the best rates.
- MyFICO.com: Credit Basics – Know Your FICO Scores, Improve Your FICO Scores, Save Money
- Edmunds.com: How to Get an Auto Loan During the Credit Crunch
- Cars.com: Understanding Your Finances
- Bankrate.com: Loan Interest Calculator
- Federal Trade Commission: The Fair Credit Reporting Act (Section 611/p.45-50)
- MSN Money: 9 Fast Fixes for Your Credit Scores
- The New York Times: Getting the Best Rate on a Car Loan
- Bank for International Settlements. "Liquidity Coverage Ratio (LCR) - Executive Summary." Accessed Oct. 5, 2020.
- Bank for International Settlements. "Basel III Transitional Arrangements, 2017–2027." Accessed Oct. 5, 2020.
- Federal Reserve Bank of Richmond. "US Bank Capital Regulation: History and Changes Since the Financial Crisis," Page 12. Accessed Oct. 5, 2020.
Ciele Edwards holds a Bachelor of Arts in English and has been a consumer advocate and credit specialist for more than 10 years. She currently works in the real-estate industry as a consumer credit and debt specialist. Edwards has experience working with collections, liens, judgments, bankruptcies, loans and credit law.