3 Things Car Buyers Need to Know About Credit Scores

If you're in the market for a car, here are three credit-related lessons to learn before you start shopping.Image source: Getty Images.

If you're in the market for a new (or used) vehicle, there are several credit-related things you should know. For example, did you know that you can shop around for the best interest rates offered by as many banks, online lenders, and credit unions as you want without hurting your credit score? Or did you know that raising your credit score by just a little bit could potentially save you thousands on the price of your car loan? And do you know how your car loan could impact your credit score after you get it?

Here's what new and experienced car buyers should know about these three important credit topics before heading into a dealership.

1. You can apply for as many loans as you want -- without hurting your credit more than a single application would

It's a popular misconception that every time you apply for a loan, it dings your credit score. In fact, my wife and I are in the car-buying process right now, and after I told her that I applied with four different lenders to compare the interest rates I can get, she asked why I'd do that when it would be terrible for my credit score.

To be fair, this misconception is based partly in truth. The FICO credit scoring formula counts hard credit inquiries in the "new credit" category, which makes up 10% of your score, and too many credit inquiries can seriously lower your score. Even one can lower your credit score, but only by a few points in most cases.

However, there's a provision in the FICO® Score rules that encourages you to shop around for the best auto loan. So long as all of your auto loan inquiries take place within a "normal shopping period," which is defined as two weeks, only one inquiry will affect your credit score. In other words, it doesn't matter if you apply for one car loan or a dozen; the effect will be the same.

Shopping around can be a big money-saver. Of the four lenders I applied with, the difference between the lowest and highest APRs I was offered was nearly 3 percentage points. That can make a big difference over the term of a five-year car loan.

2. You don't need a great credit score to buy a car, but it sure helps

An auto loan may be the easiest type of financing to get if you have bad credit. In fact, roughly one-fourth of all car loans made in the U.S. are made to subprime and deep-subprime borrowers.

An auto loan is a "secured" form of debt, meaning that it's backed by your property -- i.e., your car. If you don't make your payments, the lender can repossess the car and sell it in order to get some money back. With that collateral, lenders are willing to take a bit more risk than they would when extending unsecured financing such as of a personal loan or a credit card. That's why even borrowers with low credit scores can qualify for auto loans. And if you have a stable job and sufficient income to repay the loan, you may be able to get an auto loan even if you have a terrible credit score.

That said, just because you can get a car loan with awful credit doesn't mean it's a good idea. Interest rates for subprime car loans can be extremely high. Here are the national average APRs for a 60-month new car loan and how they would change your loan cost on a $30,000 new car:

Data source: myFICO.com.

3. How will your new car loan will affect your credit score?

Another thing that's important to know, especially if you're getting your first-ever auto loan, is how it could impact your credit score after you've bought the car. First, consider the five categories that make up your FICO® Score:

•         35% -- Payment history
•         30% -- Amounts owed
•         15% -- Length of credit history
•         10% -- New credit
•         10% -- Credit mix

With that in mind, here's what to expect. A new auto loan is generally a negative factor in your FICO® Score in the short term. It will increase your loan balances relative to their original amounts, which hurts you in the "amounts owed" category. It's also a new account, so it will bring down the average age of your credit accounts, which works against you in the "length of credit history" category. While adding an auto loan to your credit report improves your "credit mix," it's a negative factor in the "new credit" category.

To be clear, there's no way to know exactly what your credit score will do after you get an auto loan. When I obtained my first-ever auto loan, my score dropped by about 15 points after it appeared on my credit report.

That said, an auto loan should be a positive factor in the long term, assuming you make the payments on time. Payment history is the biggest part of your credit score, and as your loan balance gets smaller it will help you in the "amounts owed" category. As the account ages, the "length" category will improve, and before long it won't be a "new credit" account at all.

The takeaway is that it's reasonable to expect your FICO® Score to take a mild hit after you get an auto loan. However, keep in mind that the negative impact isn't likely to last long, and over the long run, an auto loan with a track record of on-time payments will become a major positive factor.

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