How to build credit for a new car loan

You want to get a good deal on a car loan but worry it will be challenging due to your credit health. On average, borrowers with strong credit will be offered the best rates. For example, according to Experian, those with a score of 300 to 500 have an average APR of 21.55 percent for a used car, while those with a score of 661 to 780 have average rates of 9.36 percent.

If you can hold off on buying, you can implement strategies to build your credit before buying a car. Be mindful that the lender will likely assess your ability to afford the loan by computing your debt-to-income ratio. Consider paying down any existing debt to bring down your DTI ratio alongside other methods of improving your credit score.   

4 ways to build your credit before buying a car 

Your credit rating plays a significant role in the interest rate you receive for a car loan. So, you want to get your credit in tip-top shape before you apply, starting with these actionable tips.   

1. Dispute errors on your credit report  

Start by getting a free copy of your credit report. Review the contents for accuracy and highlight any errors you notice that could drag your score down. For example, perhaps the report states you missed a payment when you actually paid it on time. Next, file a dispute by mail, phone or online with the major credit bureaus — Experian, TransUnion or Equifax — reporting the inaccurate information.

The credit reporting agency will contact the creditor or lender to further investigate your dispute. If the information in your report isn’t verifiable, it will be removed, and your score could improve.

2. Pay your bills on time  

Payment history accounts for 35 percent of your FICO credit score. If your credit card or loan account reaches 30 or more days past due, a lender or creditor will likely report the delinquency, and your credit score could take a hit.  

But if you make timely payments on your credit accounts, your score could improve over time. It is equally important to bring any past-due accounts current to avoid further collection activity and damage to your credit score.  

3. Lower your credit card balances 

The FICO credit-scoring model favors consumers that responsibly manage their debt obligations. Consequently, the amount of debt you owe is the second-largest component of your credit score. Credit utilization, or the percentage of your credit line you’re currently using, is the second-largest component of your credit score. 

Lenders like to see your credit utilization at or below 30 percent. If yours is higher, work towards paying down your balances to possibly raise your credit score and qualify for a competitive interest rate on an auto loan.  

4. Avoid applying for new credit  

Each time you apply for credit, a hard inquiry is generated and can drop your credit score by a few points. Even though the impact is temporary, multiple inquiries in a short period could hurt your score.

Unfortunately, a slight drop in your credit score could also mean a higher interest rate — and consequently could cost you several hundred or thousand of dollars more. Aim to keep shopping within a two-week period.

How credit score works

Understanding how your FICO score is calculated can help you more effectively work to improve it.

• Payment history: Making up 35 percent of your score, this includes your payment information, delinquencies and number of accounts.
• Credit utilization ratio: 30 percent. This measures the amount you owe against your credit limit.
• Length of credit history: 15 percent. Typically, the longer you’ve held credit, the better.
• New credit: 10 percent. Credit bureaus assess how many accounts you have opened recently. Opening too many new accounts can drop your score.
• Credit mix: 10 percent. Having several types of credit — including cards, loans and retail accounts — plays in your favor here.

Why your credit score matters when getting a new car 

Lenders use your credit score to gauge your creditworthiness and the likelihood that you’ll default on your loan payments. You pose less risk to the lender if you have good or excellent credit. In turn, you will generally be rewarded with a lower interest rate.

With a lower interest rate, your monthly payment will be lower, and your loan will cost less overall. Conversely, bad credit auto loan rates are typically higher.

Bad credit car loan options 

If you’re having trouble getting approved for a car loan, there are bad credit options. For example, buy-here, pay-here dealerships cater to borrowers with credit challenges — but often charge steep interest rates and should only be used as a last resort.  

Consider reaching out to your bank or credit union first to determine if they will approve you for a loan based on the strength of your existing relationship. Online lenders could also be a good fit, and many feature a prequalification tool on their website so you can see if you are eligible and view potential loan rates.  

The bottom line 

A strong credit score, a steady source of income and a low debt-to-income ratio could get you a good deal on an auto loan. So, it’s worth improving your credit health before you apply. And when you’re ready to apply, you should shop around to find the best options for your financial situation.