A Millennial’s Guide to Buying a Car without Messing Up Your Credit

Many millennials find themselves without much credit to their name, even after graduating from college. Recently, the number of consumers younger than 25 with established credit has decreased. The 2017 report CFPB Data Point:Becoming Credit Visible states that 8.9 percent of people establish credit with an auto loan, though a high percentage of those needed a co-signer. Is this a good opportunity? Or a bad idea? It turns out that the answer isn’t so cut and dry.

We asked finance experts for advice about how Millennials can use a car purchase to build credit, without messing it up.

What are you building credit for?

"First, we really need to understand what the reason behind building credit is in this case,” says Mike Scott, Senior Mortgage Loan Officer with Independent Bank.

What are your motives? Scott says, “Are you looking to buy a home in the near future, or are you simply looking to build a long-term credit rating?”

If you are purely looking at buying a car as a way to establish and build your credit, this might not be the best route.

Instead, Scott advises:

"To build credit, I strongly suggest starting with a secured credit card (assuming you have absolutely no credit) from a local credit union. The credit union cards will typically have a lower interest rate than those from other banking institutions. The first month that the card is active, use it to pay for everything that you would normally pay cash for, until the balance on the card is within $50 of the limit. When that happens, stop using the card and wait to receive the statement. When you receive the statement, pay the card off in full to avoid paying interest charges. From that point on, ensure that your card balance on the statement is no more than 10 percent of the available credit. Once the card has been in place for six months, the next step is to apply for two other credit cards that are not secured cards.

Some factors that impact a credit score include proportion of the current balance reported to the available credit limit and how long accounts have been established. For the first year or two, you can expect that the new accounts will bring a credit score down some. For this reason, avoid closing credit card accounts, as closing the account can lower your credit score.

Now, to an average person, $500 owed on credit card means that they owe $500. To a credit bureau, if they owe $500 on a $500 card, they are maxed out, a poor credit risk, and the score goes down. If they owe the same $500 on a card with a $5000 limit, they are a good credit risk and the score goes up.

As a result, if someone tends to pay the card off every month, it would actually behoove them to pay the card twice a month: once when the statement billing cycle is about to end, and again after the bill comes out, making sure that the balance showing on the bill stays at under 10 percent of the available credit limit. Once credit has been established slightly, adding a car loan into the mix can be a good thing."

Is a car loan a good way to boost your credit history?

If you can afford to pay for a car in cash, then do it. Financing a car purchase is not a golden credit-building opportunity. ***“Saddling yourself with unnecessary high-interest debt is a bad way to build credit,” explains Credit Industry Analyst, Sean Messier with Credit Card Insider.

While it's possible to finance a car with limited credit, Messier says it's not necessarily the right course of action:

"If you’re dealing with limited credit and can avoid financing your new vehicle, you should absolutely do so, because any loan you’d be able to secure would likely have frustratingly high interest rates.

If possible, pay for your vehicle with cash, and consider alternative credit-building methods, like secured credit cards and credit builder loans, which can cost you much less than a traditional loan while still bolstering your credit scores.”

If you are in a position to pay cash for a car, but just wondering if a car loan is a good way to boost your credit history, it’s not.

Can you finance a car with limited credit?

Not every Millennial wondering about using a car loan to establish credit can pay in cash for a car. “The unfortunate reality,” says Messier, “is that you won’t always be able to cover the price of your vehicle with cash, so it might simply be necessary to use financing. The good news? There are ways to finance a car without descending into crippling debt.”

In this case, he has three suggestions:

• “If you can find a co-signer that you trust, and who has better credit than you, you’ll likely have access to loans with much better interest rates.”
• “Make a large down payment, if possible, to keep the amount that you’re financing to a minimum.”
• “Shop for loans carefully, and examine all your options. More favorable terms are often available through credit unions and online lenders, rather than big-league banks. "

How can a car loan help your credit?

Edith Muthoni is Chief Editor of the investing education site Learnbonds.com. Prior to that, she worked in the banking and the Fintech industries for 16 years. She explains:

“A car loan can help build your credit in several ways. First, the average price tags of most cars require financing, which can be done in installments of two to five+ year plans. By making payments on time, you can build your credit score which will, in turn, help build a positive credit history.

Lenders look at your credit history when deciding whether to give you a loan or not. In fact, up to 35 percent of your FICO credit score is derived from your payment history. Besides helping to improve on your payment history, auto financing contributes to your credit mix and new credit which, when combined, constitute 20 percent of your credit score.

So it is easy to see why buying a car with a loan and making increased monthly payments can impact over 50 percent of your FICO score.To begin with, you will be required to make a sizeable down payment and pay monthly financing charges.

Overall, it is always a good idea to finance a car even if you have the cash. You can invest the amount in an interest-bearing account at a much higher rate than the amount you are paying for the car."

However, the interest-bearing account will have to beat your loan rate to be worth it.

Why would you get approved if you have bad credit?

Jake McKenzie, Content Manager, at Auto Accessories Garage explains, “Buying a car is a great way to build credit, because often an auto-loan is the easiest type of loan to get. The reasoning behind this is, the bank or lending institution knows that in the worst case scenario, they could always repossess the car if you stop paying for it.”

Is it good to make a big down payment?

“Paying your loan on time will help build your credit,” says McKenzie, “but if that is the sole purpose of the loan, you don’t want to be throwing money away either. What you want is the lowest possible percent of interest. If a larger down payment can lower your interest rate, by all means go for it!”

“Making a big down payment will give you less to pay over time and decrease your monthly payments,” says Jory McEachern, Director of Operations at ScoreShuttle.

Scott says that this depends on your goals. “My advice is to make a down payment big enough to keep the actual car payment at less than 10 percent of your monthly income if you are financing the car for 4–5 years. That gives you flexibility to pay more on the car when you can, without forcing the larger payment.”

What kind of rates and terms will you see?

"The best case scenario is 0 percent APR,” says McEachern. “The worst is a high interest rate over a long period of time. Your credit score can affect your terms for paying a loan, for example: A borrower with excellent credit may qualify for a lower interest rate on an auto loan, excluding other unique specials each dealership may have to offer. Meanwhile, a consumer with poor credit may see a higher interest rate. When you add up the extra costs over the life of the loan, the borrower with a lower score would end up paying a lot more in interest for the exact same vehicle!"

This is the scary part that you want to avoid.

If you start your credit from scratch, as Scott suggested, “with a secured card, at the end of six months you should have a score in the mid-600s. As such, you should qualify for terms that are possibly not the best, but should be far better than the worst.”

“If you have no score,” he says, “expect to pay 16–21 percent on the car loan, even with a nice down payment.”

“Conversely,” he says, “with a score in the mid-600s (650 or so), you should be able to get a rate a few points above prime, and about half or less what you would pay without a score. In a best-case scenario, and with a nice down payment, you may get a rate of prime (currently around 5.25 percent).”

McKenzie warns, “You don’t want to go over 60 months on your loan either. Even if you’re building credit, an extra-long loan will be doing more harm than good on your personal finances. Consider 36–48 months as your sweet spot.”

Is it worth it to make bigger monthly payments?

If credit building is your goal, McEachern says, “Paying increased monthly payments is not recommended.”

Scott warns, “What many people make the mistake of doing ... is taking out the loan and paying it off in less than 12 months.” While that may sound awesome to be debt-free so quickly, he urges consumers to “Remember that one of the things that impacts a credit score is how long accounts have been open. The account should stay open at least 18, if not 24 months or longer, in order to positively impact a credit score. Accounts that are paid off in less than six months don't have the adequate time to raise the score and improve it."

"Again, we are talking about long-term planning,” he says. “Before paying off a car faster, make sure that you have an emergency fund. Life happens. Also, make sure that you take at least 24 months to pay the car off, so that you are establishing the long-term willingness to repay that the credit bureaus are looking for.”

If you are capable of paying in cash, but want to use financing to build credit, what kind of loan should you use?

Scott says, “The process should be the same regardless of ability to pay cash.”

“For one thing, never tell the dealership that you are paying cash. Financing the vehicles is actually a source of income for them, and they may not discount the car as much if they think you will pay cash.”

McEachern suggests, “Speak with your bank or credit union, who may offer you better terms or interest rates on your loan.” Scott agrees that you should check on rates with your bank or credit union before you head out to the dealerships. “This way,” he explains, “you can at least know what your existing options are, rather than flying blind. The dealers can often beat the local bank's options, but you won't know and may end up paying a higher rate simply because you did not bother to check.”

If this is your credit building strategy, what dealer add-ons, fees, and financing contract terms should we look out for?

“Stay away from almost everything,” says Scott. “This is where the dealers make money.
Car warranties are often marked up $1,000–$2,000 over dealer cost. Believe it or not, that is often more markup than there is on the actual vehicle. . . . I do recommend an extended warranty on the car, but not at a ridiculous price. Whatever they quote, expect to be able to get at least $1,000 off that price unless you run into one of the less snakey dealers.”

“Car dealerships often try to add extra costs at the end of the sale,” adds McEachern. “Some may be beneficial to you, such as a security lock, which could lower your insurance rate. It is a case-by-case scenario. Be strategic, be careful about add-ons, be wary of customization.”

That’s not to say that all add-ons are a bad idea. “Unless you are putting a large down payment on the vehicle (30 percent or more),” Scott advises to get the gap insurance, but beware of the dealer markup. He says, “When the dealer offered it to my wife and me, they initially quoted a cost of $1,100 for it. I was able to get it for less than half that by the time we were done. They try to quote it as a monthly payment difference, so $20 per month does not sound bad, but they were still marking it way up.”

Should you just pay in cash and build credit elsewhere?

McEachern points out, "Buying a car will build credit, as it is a large ticket purchase. It will help to diversify your credit profile. Using an installment loan will show a positive payment history."

Scott says that this decision all comes down to your long-term goals. He says that if you are planning to purchase a home in the next 18 months, you may just want to pay in cash if you can. He says, “being debt-free may be better, and having a few credit cards may be enough credit to qualify for a home loan.”

The bottom line

Using a car loan to build credit is certainly an option; however its usefulness will depend on your current credit and your long term credit goals.

If you are able to pay in cash and just looking to build credit, there are better ways that are less risky, unless you are ready to finance the car and simultaneously invest in a high-yield, interest-bearing account that makes you more money than you are paying on your interest. This isn’t likely if you don’t have the credit score to get a low rate.

If you aren’t able to pay in cash and you do need to finance, try to start establishing credit with Scott’s advice, more than six months before you plan to purchase. Stay in the 36–48 months loan term sweet spot, and don’t pay it off sooner than 24 months. Get a co-signer if you can, and make a large down payment if possible.

Lastly, if you plan to buy a house in the next 18 months, the usefulness of a car loan may not be the best idea. Paying in cash for a car may be the best option, considering your bigger financial purchase in the coming months. Check out other credit building opportunities to help get purchase-ready.