Building credit while paying off a car loan

by Mahindra Finance

April 17, 2024

4 mins read

Are you thinking of financing a car? Many of us require some form of financing to purchase a vehicle, but have you ever wondered if a car loan can help build your credit? The short answer is yes, but it's important to understand how the process works.

In this article, we will demystify the relationship between car loans and credit scores and how to increase credit scores with car loans. So let's dive in and learn how to increase your credit score while paying off a car loan:

How does a car loan affect credit?

Before we delve into 'how to increase credit scores' while paying off a car loan, let's quickly understand how a car loan EMI can impact your credit score. When you apply for a car loan, the lender will pull your credit report, resulting in a hard inquiry. This may cause a temporary dip in your credit score. However, as long as you make consistent, on-time payments towards your loan, your payment history will gradually boost your score over time.

Your debt-to-income ratio is another aspect that is influenced by taking on a car loan. Adding this new debt may increase your total debt amount and negatively impact your credit if you already have high levels of debt.

Now that we have an overview of how a car loan affects credit, let's explore the steps you can take to improve your credit score while paying off a car loan.

1. Make timely payments on your car loan

One of the most significant factors in determining your credit score is your payment history. Making timely car loan EMI payments demonstrates responsibility as a borrower and can significantly boost your credit score over time. Each on-time payment adds positive information to your credit report, helping to offset any negative impact from the initial hard inquiry.

2. Manage your debt-to-income ratio

As mentioned earlier, taking on a car loan increases your total debt. It's crucial to consider this when managing your debt-to-income ratio (DTI). Your DTI is calculated by dividing your monthly debt payments by your monthly income. Lenders use this ratio to assess your ability to manage additional debt responsibly.

3. Monitor your credit utilisation ratio

Your credit utilization ratio is another key factor that affects your credit score. It measures the amount of available credit you are using, compared to the total credit limit across all accounts. A lower utilisation ratio and consistent payments towards your car loan EMI indicate responsible borrowing habits and can help improve credit scores.

4. Diversify your credit mix

Lenders prefer borrowers who have a diverse credit mix and have demonstrated their ability to handle different types of debt responsibly. By adding an instalment loan like a car loan to your credit profile, you diversify your credit mix and improve your score.

If you don't already have an instalment loan in your credit history, financing a car can be a strategic move to build credit. However, it's important to note that this should be done in conjunction with other responsible borrowing practices such as maintaining low credit card balances and making timely payments on all debts.

Conclusion

When looking for how to increase credit scores, we have seen that financing a car can help build your credit score if managed responsibly. By making timely payments on your car loan, managing your overall debt-to-income ratio, and monitoring your credit utilisation ratio, you can improve your credit score over time.

If you're considering financing a car or need advice on managing loans while building credit, Mahindra Finance offers solutions tailored to meet these needs. They provide competitive car loan interest rates and flexible repayment options to help you achieve both, financial stability and improved creditworthiness.

FAQs

Q1: How does a car loan affect my credit score?

A: Taking on a car loan can impact your credit score in several ways. It may cause a temporary dip due to the initial hard inquiry when applying for the loan.

Q2: Can I improve my credit score while paying off a car loan?

A: Absolutely! Making timely payments on your car loan, managing your debt-to-income ratio, monitoring your credit utilisation ratio, and diversifying your credit mix can improve your credit score while paying off a car loan.

Q3. Why did my credit score drop 100 points after paying off my car?

Your credit scores drop after paying off debt because of a change in the types of credit. An increase in the overall utilisation or a decrease in the average age of your accounts is one reason for this.