Your credit score is one of the most important factors in financing a car. Simply put, credit scores measure the likelihood of people paying back loans. When you go to buy a car, whether you’re buying from a private seller, dealer or on an online auction site, your credit score can strongly impact your ability to obtain financing and the interest rate you receive.
What credit score do I need to buy a car?
The answer: it depends. Credit scores are most commonly gauged on a scale of 300-8501. The higher the score, the better your credit. Better credit means lenders believe there is less risk in extending you a loan. Having a low credit score could mean that you won’t qualify for a loan or be offered the lowest interest rate available - and as a result, you’ll pay more over the life of the loan.
Lenders commonly assign certain designations to credit scores to identify high and low risk loan recipients. If a lender determines that an applicant is low-risk (i.e. has a high credit score and minimal outstanding debts), he or she will probably be more willing to offer a loan at a favorable interest rate.
There isn’t a specific credit score needed to buy a car, but typically, the higher the score, the better your interest rate. If you have a low credit score, a used car purchase could be an option you may want to look into. Lenders may be more willing to offer you used car financing because the cost is typically lower than that of a new car, constituting less risk for the lender.
What other factors are considered?
An excellent credit score doesn’t guarantee an auto loan at a low interest rate. Lenders also consider the following factors in order to get a big-picture look at your creditworthiness before offering you financing options.
- Debt-to-income (DTI) ratio. If you’re looking to borrow a large amount of money, it’s only natural for lenders to want to see your current financial situation. Enter the debt-to-income (DTI) ratio, a measure of how much you earn compared to your current debt in credit cards, student loans and existing auto loans. This calculation allows lenders to see if you’re “living on the edge,” so to speak - as in, how much of a financial margin you really have after all debts are paid each month. An exceptional credit score tells only of making payments on time and keeping balances low or paid off, while the DTI indicates your actual spending power.
Lenders look at two different types of DTIs: the front-end ratio and the back-end ratio. The front-end ratio shows the percentage of income that would be needed to pay housing expenses, including your monthly mortgage payment, real estate taxes and homeowner’s insurance, while the back-end ratio factors in these housing costs plus all other debt payments each month, such as credit card bills and student loans. To find your percentage of either, simply add your monthly expenses and divide by your monthly income. The mathematics of improving your DTI are simple: decrease your existing debt (or increase your income).
- Amount you borrow. The amount you’re looking to borrow plays a factor in whether your application is approved. During the underwriting process, lenders use the proposed loan amount to calculate your DTI and assess your risk as a borrower. Your interest rate will likely vary by loan amount, as a greater loan is perceived as a greater risk to the lender.
- Term of the loan. Choosing a shorter or longer term of repayment can often impact whether the loan is approved or declined. When applying for your auto loan, it’s important to understand your objective: to pay off the loan quickly or to have a low monthly payment. As a borrower, you’ll want to consider your monthly budget and how your financial picture may change in the future.
- Loan-to-value (LTV). Lenders will also consider the total dollar value of your loan divided by the actual cash value of the car, also known as the LTV. For those with a high ratio, the lender may charge a higher interest rate to compensate for any potential losses. To improve your LTV, you may make a down payment on the vehicle at the time of purchase - and some lenders may require this.
- Vehicle mileage. In addition to the value of the car, some lenders may evaluate the car based on the mileage it has. This could mean that a lender may charge a higher interest rate on cars with high (such as 100,000+) mileage, or the vehicle may be deemed ineligible for the loan, depending on any mileage limits in place for a new auto loan or refinancing. This is because cars with higher mileage have an increased likelihood of mechanical issues and the costs associated with these issues can become an additional financial burden on the owner. To lessen the risk, lenders may place a cap on the repayment term or the amount that can be borrowed. The restriction to the borrowed amount is typically a percentage of the current market value of the vehicle.
- Credit history. Lenders will often review your prior credit history to understand expected future performance. Late or missed payments can impact the interest rate you are offered for the auto loan or whether your application is approved. If your credit situation has improved recently but your application was declined, it may be worth reapplying after time has passed, as lenders often review payment history for only the past year or two. However, there are some negative credit findings that may be evaluated for longer than two years, such as bankruptcy.
Knowing your credit score upfront and where you are on the credit spectrum can save you negotiation time and hassle when buying your next car. You should be able to check your credit score regularly with the free report available from the major credit reporting agencies once a year and from services like Credit Karma.