A reader of the blog, Andrea from Andrea's Original, recently sent in a question about car loan and improving credit score:
Hi there. I have a question that maybe you can help me with. My husband has slightly lower than OK credit, and he's trying to build it up. He did file bankruptcy about 2 years ago. He's only 27. We have Juniper credit cards which give a free (semi-accurate) credit score, and tips on how to make it better. One of his tips was to get a car loan. So he's driving his car off the lot today. We do have the money to pay the loan off tomorrow, we could have bought it outright but instead put 6K down and borrowed 4.5K. The payments are roughly $100 a month for 4 years at a rate of 7%.
Ok here's the actual question. What is the best way to use this loan to increase his overall credit score? Should he pay it month to month, and for how long before paying it off? Should we just pay it off in a month? If we pay it month to month will making 2 payments a month help more? We have a baby due in June, with that comes all the baby expenses including daycare, so I am happy that the monthly payment is so low, but would still like to pay it off sooner rather than later, but repairing his credit is obviously more important.
Thanks! – Andrea
Andrea's hubby's dilemma: What's the best way to use a recently acquired car loan to increase overall credit score?
Need to know terms: (yeah it's slightly boring but you'll need to know it)
Installment credit: An installment credit is a type of credit account where you have a fixed number of equal payments through the duration of the payment period. Examples of installment loans are auto and home loans. In Andrea's situation, their car loan has a monthly fixed payment of about $100, at 7% APR, and the loan's term is 4 years.
Revolving credit: A revolving credit is a type of credit account where you don't have a fixed number of payment. Borrowers will continue to be able to have access to credit again and again as they make payment towards account.
A credit card is a prime example of a revolving credit account; for example, you may have a $1,000 credit limit card, and you make $900 in purchases and now you'll only have $100 left in credit to spend on the account. Once you pay off the $900, you'll be able to use your entire $1,000 credit limit account.
Why Would Getting a Car Loan Help Andrea's Husband's credit?
Without knowing fully their situation and why the Juniper website made the recommendation, we can assume that a car loan was suggested as a means to mix up her husband's credit profile.
As listed above, there are two types of credit accounts you should be aware of, installment and revolving credit. People generally will have a better credit score and credit worthiness if they have a mixture in types of positive credit accounts.
If all else is equal (age of account, positive payment history, etc.), a person with a mixture of revolving/installment credit should have better credit score than a person without the mixture of accounts. From a lender's viewpoint and a credit scoring perspective, this shows that the person in question has been trusted with various type of credit accounts, and was able to manage different type of accounts and paid them on time without issues.
Things Andrea and Her Husband Can Do:
1. Pay off car loan within the month and save money on interest.
2. Pay off car loan at regular schedule of ~$100 a month for the next 4 years.
3. Make double payments per month and pay off the car loan in about 2 years.
In the first scenario, if they pay off the car loan within the month, they will save about $1,200 in interest over the next 4 years. That's a lot of money being saved, considering it's over a quarter of the actual $4,500 loan! As they've already acquired the car loan, the account is already in the credit history. Once paid off, it would be marked as Paid/Closed, and it would end as a positive credit line in the credit history, thereby improving Andrea's husband's credit profile.
In the second scenario, Andrea and her husband can make regular payments at about $100 a month for the next 4 years, but this will end up costing them $1,2000 in interest. Not a small sum, but because of potential future expenses with the arrival of the awesome newborn, it may also be a good idea to have some cash cushion on hand for difficult times. If they make regular payments, their credit will slowly be improved as the debt is reduced, the age of account lengthens, and the accumulation of on-time payments continues.
In the third scenario, Andrea and her husband can make double the regular payments per month, thereby reducing the length of the loan duration and save about $600 in interest. They will also be slowly improving their credit during the loan repayment time, and should arrive to a better credit score slightly faster.
So there you go Andrea! The first scenario seems like the best way to go in terms of getting immediate benefit from this new installment credit (car loan), and the best way to go to save money on interest charges. If your husband and your incomes are stable and you've already have a healthy cash cushion, then this should be the best course of action. Suggestion: you can always potentially plan and budget possible expenses for the next 1-2 years, just to see how much of an impact paying off the $4,500 loan will do.
If anyone else reading has further input on this edition of "Ask BillShrink Guy," please chime in by the comment section. If you have a general personal finance related question, feel free to Ask BillShrink Guy!
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photo credit: thetruthabout
