Your old car needs expensive repairs and you've decided to skip the costly repairs and go to the local dealership and look for a new one. After going through your budget, you've determined that you can afford a reasonable payment for a new car. But did you know that your credit score is going to affect the amount of your car payment? And ultimately, your credit history may even affect your choice of cars, and you might not be able to buy the one you really want.
Let's examine how your FICO credit score can affect the interest rate and amount of your car loan and what you can do to improve it.
How Much of a Car Loan Payment Can You Afford?
Let's start out with a few statistics to put things in perspective. According to recent data from Experian, 85 percent of new vehicle purchases and 55 percent of used cars are financed with a loan, not paid in cash. The average new car loan is slightly over $32,000 at a rate of six percent, while the average loan for used cars is a little more than $20,000 with an average rate over 10 percent.
Monthly loan payments for new cars average $554 over 68.9 months. Payments for used cars average $394 per month over 64.7 months.
As a general guideline, your car loan payment should not exceed 10 percent of your after-tax income. In addition, your total transportation cost, including insurance and gas, should not exceed 20 percent of your after-tax income.
For example, if your gross annual income is $65,000, and you bring home $4,300 per month after taxes, your monthly loan payment should be no more than $430.
Read More: What Documents Do I Need to Get a Car Loan?
Effect of Credit Scores on New Car Loan Rates
Your credit score will have a significant effect on the interest rate that lenders will offer you for a car loan. According to the latest data from Experian, the current interest rate by credit score classification for a new auto loan is as follows:
Deep subprime – below 579: 14.39 percent
Subprime – 580 to 619: 11.92 percent
Nonprime – 620 to 659: 7.65 percent
Prime – 660 to 719: 4.68 percent
Super prime – above 720: 3.65 percent
This data shows that a buyer with a “deep subprime” credit rating would pay four times (14.39 percent/3.65 percent) as much in interest as a buyer with a “super prime” score. This difference will have a huge effect on the amount of a car loan payment.
Suppose a buyer wanted to purchase a car for $30,000, make a down payment of $3,000 and finance the remaining balance of $27,000 for six years. A buyer with super prime credit would have a monthly payment of $418, while a buyer with a deep subprime credit score would have to make a payment of $562 per month. Over the life of the loan, the buyer with the lower credit score would make total interest payments of $13,465, while the buyer with the higher credit score would only make total interest payments of $3,105.
This is a difference of $10,360 ($13,465 minus $3,105).
Read More: Will a Score of 67 Get You a Car Loan?
Effect of Credit Scores on Used Car Loan Rates
Interest rates on loans for used cars are slightly higher for buyers with good credit and significantly higher for buyers with less-than-stellar or bad credit scores. Compare these rates from an Experian survey for used car loans to the new rates for new-car loans listed above:
Deep subprime: 20.45 percent
Subprime: 17.74 percent
Nonprime: 11.26 percent
Prime: 6.04 percent
Super prime: 4.29 percent
A buyer with a deep subprime credit rating will pay nearly five times as much in interest for a used car loan as a buyer with a super prime score (20.45 percent/4.29 percent).
For comparison, let’s look at the example of a buyer financing $27,000 for six years, but this time for a used car. A buyer with a super prime score would have a monthly payment of $426, but the buyer with a deep subprime score would have to make a monthly payment of $654.
The super prime buyer would make total interest payments of $3,672 over the life of the loan, while the deep subprime borrower would make total interest payments of $20,073. A difference of $16,401 ($20,073 minus $3,672).
Read More: What is a Prime Credit Score for an Auto Loan?
What Credit Score is Needed for a Car Loan?
The reality is that almost anyone, including those with bad credit scores, can get a car loan. The problem is that buyers with poor credit will be paying substantially more in monthly payments because of their low credit scores. Even further, the difference in credit scores will limit the amount that someone could pay for a car.
Suppose you have an annual income of $65,000 with a net monthly income of $4,300. If we follow the guideline of not exceeding 10 percent of net monthly income for a car payment, then a buyer with a deep subprime credit score would be limited to financing $20,000 at an interest rate of 14.39 percent.
A deep subprime buyer who wanted to purchase a car costing $30,000 would have to make a down payment of $10,000 to stay within these monthly payment guidelines.
On the other hand, a buyer with super prime credit and the same income would be able to get an auto loan up to $27,000 at an interest rate of 3.65 percent due to her good credit score. This buyer would only have to make a down payment of $3,000 to purchase that same $30,000 car.
How to Improve Your Credit Score
As you can see, your credit score will have a huge impact on your monthly car payment and even the amount that you can pay for a car. These differences can add up to thousands of dollars. Here are a few ways to improve your credit score:
Get a copy of your credit report – Review your credit report and look for any errors or omissions. If you find errors, contact the credit bureaus to make corrections.
Pay off any collection agencies – Any delinquent debt that is reported to collection agencies has a large negative impact on your credit score. Contact these collection agencies and pay off the amounts due. The account will still show on your credit report, but at least it will show as having been fully paid off and will have less and less impact on your credit score over time.
Bring any past-due accounts current – It’s better to work with creditors on a payoff plan to bring past-due accounts current before they are transferred to collection agencies.
Pay down credit card debt – Lenders prefer to see credit card debt at no more than 30 percent of the total credit lines.
Pay all of your accounts on time – A record of continuously making on-time payments will gradually improve your credit score.
Improvements in your credit score will not take place quickly. It will take time for your efforts to produce results, but a higher credit score will have a significant impact on your financial budget and save you thousands of dollars.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.