Understand How Your Credit Score Affects Your Car Loan

Of all the consumer products available to us, a new car is one of the most desired. The excitement that surrounds the purchase of a new car can’t be matched by the purchase of a refrigerator, washing machine, or living room rug. Vehicles are exciting, dynamic products. They are also expensive products, and that is a factor that makes them both enticing and challenging to buy. With the average transaction price for a new vehicle well over $30,000, a new car is a goal that not everyone can attain.

The good news is you don’t have to have $30,000 saved up to buy a new vehicle. Instead, most of us can obtain a loan that will bridge the gap between what we can spare from our bank accounts and the price of that bright, shiny vision of glass and chrome. The reality is that not all car loans are created equal. Instead, the car loan you get is based in large part on the information that is buried in your credit score.

Before diving into the vagaries of individual credit reports and credit scores, it is valuable to get a grasp of consumer lending in this era. Fueled by the extensive use of credit cards, consumer credit has become a mainstay of the economy.

In a departure from common practice as recently as 50 years ago, most consumers don’t save their money to buy things they need and want. Instead, they buy them now depending upon their credit, which can be looked at as their expected ability to pay back that debt with, of course, the interest on the money that makes the transaction palatable for the lender. What lenders want is for you to pay back the loan on time. What they don’t want is risk. And the major risk for them is you won’t pay it back.

Your credit history, credit report, and credit score are all efforts that attempt to predict how risky it is to lend money to you. Your credit report sums up all the pertinent pieces of information the company that compiles it can find out about you.

The three major credit reporting bureaus — Equifax, Experian, and TransUnion — collect information about your current and past financial dealings. Among the factors they examine are payment history, the amount of debt you are currently carrying, the length of time you have been using consumer credit, the types of credit you use (home mortgage, credit cards, home equity loans, etc), and when each credit account or credit line was established. All of this information is used to figure your credit score.

The term credit score typically refers to a number that is derived from the information that forms your credit history. It is an attempt to represent in a standard numerical way how risky an individual is to lend money to.

These days, there are several scores about individual consumers that could justify the name “credit score,” but in the typical context revolving around auto loans “credit score” most often refers to an individual’s FICO score. Several decades ago, the Fair Isaac Corporation (FICO) introduced its proprietary consumer credit score that came quickly to be known as the FICO score. Its goal is to provide an industry-standard for scoring creditworthiness that is fair to both lenders and consumers. Before the original FICO score, many different scores attempted to perform the same task. All were calculated differently and some included sex and political party affiliation among their parameters.

It is instructive to think of your FICO score as a numerical summary of your credit report. As we noted, since your credit report measures how long you've had credit, how much credit you have, how much of your available credit is being used, and whether you've paid on time, your credit score is a numerical representation of all those important factors.

The FICO score is figured in the same way for each individual, so it provides an equal playing field for assessing creditworthiness. Higher credit scores suggest a higher probability an individual will pay back loans on time, indicating that person is a lower risk than someone with a lower credit score. A FICO score helps lenders make smart, quick decisions about who they lend money to, and it also helps consumers get fair and fast access to credit when they need it.

A credit score gives the financial institution a snapshot of whether the person applying for the loan is worthy, by its standards, of being allowed to borrow the funds she or he is seeking. If you are scored high, meaning your credit history indicates a strong likelihood you will repay the loan on time, you are more likely to get the loan than an individual whose lower score suggests their chances of repaying the loan are poorer.

The lender doesn’t typically care much if at all about who you are. It simply cares about your likelihood to repay the loan according to the terms. You can get an auto loan despite having a marginal credit score, but if you do, you will almost certainly borrow the money at less favorable terms than individuals with top credit scores.

The interest rate an individual pays on a car loan is heavily influenced by the credit score. If an individual has a score indicating a higher level of risk, the financial institution charges a higher interest rate for the loan.

The difference between a stellar credit score and a poor credit score is stark. Here’s an example: Assume the purchase of a $20,000 car with a down payment of $4,000. In this scenario, the customer will borrow $16,000 and pay it back in 60 months. A person with a super premium credit score may qualify for an interest rate of 3.65%, making for a $292.14 monthly payment. In repaying this loan the borrower will pay $1,528.40 in interest for a total of $17,528. A person with a poor (deep subprime) credit score might instead qualify for an interest rate of 14.39%, equating to a $375.53 monthly payment. In repaying this loan the borrower will pay $6,531.80 in interest for a total of $22,531.80. In other words, the person with poor credit will pay thousands of dollars more for the car than the person with tip-top credit.

In addition, helping to determine the interest rate a consumer is offered, an individual’s credit score may also affect the amount of the required down payment. Because financial institutions want to limit their risk as much as possible, those with lower credit scores will often be required to put a larger amount down on the vehicle in addition to paying a higher interest rate.

The additional upfront money, which represents a higher-than-average percentage of the vehicle’s value, mitigates the risk of the consumer defaulting on the loan. Because credit scores based on your credit history, you can influence your score by paying bills on time, avoiding unnecessary debt, and being smart about credit card purchases.

Up to now, we have talked about credit scores general terms, but it is useful to get more specific. The FICO score starts at 300 and runs to a possible high of 850. Along the way, creditworthiness is divided into five “tiers.” The demarcations of those tiers vary somewhat lender-to-lender, but here is a closer look that is generally accurate.

People with scores of 781-850 have exceptionally good credit histories and are regarded as “super prime.” Those with scores of 661-780 are frequently regarded as “prime.” The next tier is 601-660, called “nonprime” or “good.” The fourth tier is “subprime” at 501-600. And “deep subprime” or “poor” is 300-500. Those with scores of “good” or better will typically have little trouble getting approved for a car loan. Those in the subprime and deep subprime categories should also be able to get a new-car loan, but the terms are often so severe one has to wonder if the purchase is a good idea.

While a consumer’s credit score is a key piece of information financial institutions use in determining if they qualify for a car loan, it isn’t the only factor. It is likely the potential lender will examine your credit report, your employment history, and your debt-to-income ratio. The last of these views your total monthly payments on debt in comparison to your monthly income.

Again, the lender attempts to determine your ability to pay back a loan. If it looks like you’ll have a difficult time making the car payment, you probably won’t get the loan. On the other hand, if your credit score looks good and all other factors are in order, you’ll get the loan and soon be driving a brand-new car.