Everyone wants or needs a car, but having a good credit score when buying a car can make the whole process easier.
But the car that you can buy or lease also depends on your credit score. Why is that and what is the connection?
Credit scores are important for big purchases and leases such as cars, personal loans, and mortgages. High or low your credit score determines how much interest you will pay over the life of the loan.
The nation’s three credit reporting agencies–Experian, TransUnion, and Equifax–gather the purchasing and payment histories as raw data. Then, Fair Isaac & Co. compiles the data to create the popular FICO score. Credit scores vary slightly from each company, but they are widely accepted as being a good assessment of a person’s financial reliability.
These scores create the following categories of borrower scores:
- Super-prime (FICO Scores of 720 or above)
- Prime (FICO Scores of 660-719)
- Near-prime (FICO Scores of 620-659)
- Subprime (FICO Scores of 580-619)
- Deep subprime (FICO Scores below 580)
When you visit a dealer to select a car, one of their first tasks will be to check your credit score for the car loan. Using this score, they can determine the all-important interest rate you will pay over the life of the loan.
Credit Scores Make a Big Difference When Buying a Car
How big can these differences be over the life of the car loan if you have a low versus a high credit score?
As an example, a person who wants to buy a car with a FICO score of 720 to 850 should be able to qualify for a fixed annual percentage rate (APR) of 4.55% on a 60-month loan for a $20,000 new car, according to Credit Karma. However, a person with a FICO score of 590 to 619 might qualify for an APR of about 16% for the same loan.
This 11.45% APR difference is huge. This means a subprime borrower, the person with a low credit score, pays $6,794 more for the car than someone with a FICO score of 720 or more.
In many cases, this could mean a borrower is paying more for the loan than the value of an older car.
Car loans also contain other associated fees. These include fees for processing or originating the loan, a fee for taking out the loan, a prepayment penalty for paying off the loan early, and a service contract (which should be optional) for repairs or maintenance service.
In general, subprime car loan recipients pay about 29% more than non-sub-prime borrowers, according to the Columbia Business Law Review.
The Federal Reserve Bank of Kansas City emphasizes that there’s no universal definition of a “subprime loan.” However, more often than not, the borrower’s credit scores define whether a loan is a subprime. Another way to identify subprime loans is by looking at the loan’s interest rate or specific lender.
The 5 Levels of Credit Scores to Buy a Car
As noted earlier, the Consumer Finance Protection Board (CFPB) defines five levels of credit scores for people who take out an auto loan. Some dealers that focus on issuing subprime auto loans even offer them to people without credit scores.
If you don’t know your credit score, you can get a report from each of the three nationwide credit reporting agencies weekly at annualcreditreport.com. Plus, as a result of the COVID epidemic and the mass layoff of many workers, the three major credit bureaus— Experian, Equifax, TransUnion — are offering free credit reports every week. This means you can monitor your credit status if you are having trouble paying bills. The free credit reports will be available on AnnualCreditReport.com through April 20, 2022.
The Car Loan Application Process and Your Credit Score
Since June 2015, subprime auto lenders have been under the jurisdiction of the Consumer Finance Protection Board (CFPB), which monitors the level of auto lending activity, including the number of loans made in different credit categories. As of January 2018, there was about $4 billion in subprime loans (borrowers with credit scores below 580) outstanding, according to CFPB data.
There are two ways care loans are offered to buyers: direct and indirect lending.
In indirect lending, the car dealer chooses the lender. After the buyer chooses the car they want, the dealer collects their credit information and fills in the consumer’s credit application information, so it can be submitted to other lenders.
Some dealers get incentives from lenders, so this can affect the final loan decision. After the credit application is checked and approved, the lender issues a risk-based “buy rate.” The dealer then writes up the installment loan sales contract.
In direct lending, the borrower chooses their lender, so it can be a bank, credit union or specialized lender. Some dealers are “buy here-pay-here” companies that issue their loans and then service the loan contracts.
Ways to Improve Your Credit Score Before Buying a Car
If you have bad credit and find that you will be paying high interest to buy a car, the good news is that your credit score can be improved.
There are established practices for repairing and improving credit scores. There are agencies that will help you do that, and you can also do this yourself by following some basic, sound bill payment practices.
These include the most important factor: paying your bills on time or even before they are due. The other key factors are: only using 30% of your available credit limit, restricting the number of credit cards you own and looking at your credit report to correct any mistakes it contains.
A good way to raise your score is to pay on time while you are reducing balances on all of your cards. Another way is to check for fraud. Identity fraud is an industry, and many people are surprised when they discover they have been the victim of identity theft.
Correct Mistakes In Your Credit Report
If you find that you have a mistake on your credit report, there are ways to correct it. According to the US Government, you can write a letter disputing the error. This letter should include any supporting documentation and be sent by registered mail to the three major credit reporting agencies (Equifax, Experian, or TransUnion).
You should also send a letter to the vendor, bank, and credit card company that was involved in the charges. The federal site even includes a sample dispute letter, as well as other detailed instructions on how to report errors.
Most consumers also don’t know that specialized companies track many of their payments. This includes firms that track bounced checks, late payments, check fraud, uses of fake identities, bankruptcies, civil court actions, and arrests. Any of these factors can find their way into a credit report. If they do, these negative events will only hurt your score.
Once you start paying on time, the reporting companies should start to reflect this positive activity in their reports. Creditors report to the three bureaus every 30 to 45 days, but not all at the same time. This means credit scores are in constant flux, so your score is updated frequently, often monthly, for each lender.
Don’t Have Your Car Repossessed
One of the reasons many dealers extend credit to people with bad credit is because the car can be repossessed. When a mortgage goes into default, companies have to wait months before they can regain title to the house in a lengthy, expensive foreclosure process.
Cars are easier to take back. Tow trucks can hook up the car owned by the delinquent buyer and drive away in minutes. Also, auto dealers are making subprime loans because of new technology. Some deals insist that a subprime borrower install a starter interrupt device (“SIDs”) in their car if they want the loan.
This device allows the auto loan lender to remotely turn off the borrower’s car if the borrower misses several payments and defaults on the loan. If the car has a global positioning system (“GPS”), the SID then sends that location back so the lender can repossess the car. In 2015, news reports found that unregulated use of SIDs “negatively affects subprime borrowers and their families,” as reported in the Iowa Law Review.
What’s a Good Credit Score to Buy a Car?
The best credit score to buy a car is the same credit score you need to get lower rates on other major purchases. A good score applies to all your purchases and it affects your employment opportunities and car insurance rates.
Having a good credit score and good bill-paying practices translates into lower interest rates and being able to afford more of the things you want to buy in life.