Can quickly repaying a car loan help rebuild credit?
Dear Credit Score Report,
I'm
trying to rebuild my credit. I took out a joint car loan with my fiancee. The
problem is we have a high interest rate. My fiancee would like to pay the loan
off ASAP to avoid paying so much in interest. Will this help my credit rating
to pay it off within six months or should I continue to make the monthly payments
to help my credit score? We are trying to get my score the best it can be so we
can eventually buy a house and weren't sure what would help my score the most.
-- Vicki
Hey Vicki,
Since a record of on-time payments are the key to building
good credit, focus on the consistency of your repayments before turning your
attention to speed.
When rebuilding your credit, experts say the most important step
is never paying late. That includes auto loans. "It really makes little
difference if the note is paid off early. The key issue is that it was paid in
full with no delinquencies," says Rod Griffin, director of public
education with credit bureau
Experian. An account that's been open for six
months and appears on your credit report will be enough to generate a FICO credit score. Therefore, based on your time line, if you've made every car payment
up to this point on or before the due date, you should be able to safely pay off
the remaining debt. "The best of both worlds would be to show a track
record of good payments, followed by paying off the loan early," says Gail
Cunningham, vice president of public relations for the National Foundation for
Credit Counseling. If you've slipped up
in the past, however, hang onto that loan for a little longer to show that you
can manage it more effectively.
Once that joint account's history of on-time payments appears
on your credit report, you can think about speeding up those repayments. As
you've already realized, paying off that car loan early will save you money on
interest payments. "If they have other debts, they can use the funds
previously committed to the car loan to reduce those debts," Griffin says.
Doing so will lower your utilization ratios -- or debt levels relative to credit limits -- and your overall indebtedness, which typically strengthens credit scores, Griffin adds. Do make
sure you won't be penalized for getting ahead of the game, however. "They
need to be sure and check the terms of the loan to confirm that there are no
prepayment penalties," Cunningham says.
There are plenty of other factors that drive your credit score
as well. For example, to get an excellent credit score, you'll need to
prove you can handle other types of accounts, too. That's because credit scoring models
typically reward borrowers who successfully handle a variety of debt, such as
auto and home loans (nonrevolving or closed-end) and credit cards (revolving).
"A vehicle loan is an example of a closed-end account, in that it is for a
set amount of money for a certain term," the NFCC's Cunningham says. "Do they perhaps have another vehicle
payment or loan that would satisfy this category, thus paying it off wouldn't
hurt? Also, do they have other open and
active lines of credit?" she asks.
If not, consider selectively opening some different account
types well before you apply for a home loan. (Since taking on new loans can impact your credit score, however, be careful about opening numerous credit
cards or other taking on additional debt obligations, particularly when you're about
to apply for that mortgage. And of course, if you can't afford to take on more
debt, you shouldn't do it -- regardless of any potential help to your credit score.) "Any
lender, particularly a mortgage lender, wants to see a thick and positive
credit file," Cunningham says, noting that a "thick" file
usually means three or more open and active accounts. In your case, that number
currently includes your existing auto loan. Look over your credit report to
make sure all your accounts are listed and get any errors get corrected. "If
closing this account would put them below that threshold, it might not play in
their favor," Cunningham says. FICO
agrees. "Generally speaking, having one or more active installment loan
accounts is better for one's score than having only closed loans, and having
only closed installment loans on one's credit report is better for the FICO
score than having no installment loan record at all," says Ethan Dornhelm, principal scientist at FICO.
Of course, paying off and closing that account early isn't
the only way to save money. Refinancing, or establishing a new loan, could bring
you better terms if your credit score has improved since you initially
purchased that car. Start by educating yourself about your current loan. You
can compare your existing auto rate to the national
averages to see how your current loan rate compares. If your credit has improved
since you initially took out the car loan, a refi should offer you a lower
interest rate. (Bankrate lets you compare auto refinance rates.) As discussed earlier, the
savings on interest payments can be put toward paying off other debts or toward
creating a savings account for that eventual home purchase.
Such responsible behavior will help you in the long run. "It
is very important to demonstrate good financial habits beyond credit when applying
for a mortgage loan today," Experian's Griffin says. "Lenders often
require a substantial down payment and may ask that you have money in savings
to ensure you can continue to make the mortgage payments in the event of
unforeseen economic challenges."
Good luck!
-- Jeremy
See related: Credit card authorized users, joint account holders differ, 'Hard' inquiries have limited credit score impact, Free credit reports: How to get the actual free one, How to dispute credit report errors Decade-old credit mistakes shouldn't appear on your report, How to cancel a credit card
Jeremy M. Simon is a former CreditCards.com reporter who wrote about credit scoring, economic data, credit card crime and other issues. He is based in Austin, Texas. He is a graduate of Vassar College and has previously worked for Thomson Financial in New York City, where he wrote about the stock markets, and Texas Monthly, as well as several publications in Austin.
Send your question to The Credit Score Report.
Published: October 19, 2010
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