How Auto Loans Affect Credit and How to Effectively Lower Your Monthly Payments

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, - May 25, 2016

Making your auto loan payments successfully is a great way to build your credit however defaulting on them can have steep ramifications also. All loans, including car loans, have a very strong influence on your credit score depending on how you pay them back.

If you're curious about how your car loan affects your credit score and what happens if you default, read below.

Getting a Loan Affects Credit

Firstly, the mere act of taking out auto loans impacts your credit score. Secondly, current outstanding loans also have an effect on your credit, so taking an auto loan may temporarily drop your credit score only until it is repaid. Lenders will be able to see that the drop in credit is due to a current loan outstanding on your credit report.

Building Credit with Loan Payments

Paying back an auto loan is a great way to restore bad credit or simply solidify preexisting good credit, while enjoying your new car. As all terms and auto loans are different, it’s impossible to say exactly how many points a single payment increases your credit score. However, you can rest assured that making payments on installation plans like car loans does have a strong, positive effect on credit.

Paying your loan off in full will not give you an extra credit boost. If you pay your car loan off earlier than originally agreed, you will not get any additional good credit however it's not a bad thing, either.

Ways to Lower Your Monthly Payments

Making a large payment toward the principal is the best option to lower your auto loan payment. By reducing your principal balance your monthly payment will shrink, and depending on the terms of your loan agreement, your interest due will shrink accordingly. Having a lower balance will also reduce early termination fees if you pay your loan in full ahead of time. The biggest downside of making a large principal payment is that you are using savings that are potentially applicable to higher interest rate debt and you are making a larger, up-front cash investment for a depreciating asset. On the plus side, you will need to pay the principal eventually, so the sooner you make a payment means that you will pay less interest.

Consolidating your auto loan with other secured and unsecured debts can also help you lower your monthly payment. While consolidation loans often have higher interest rates than auto loans, no down payment is required, and consolidating the auto loan at a higher rate will offset when other debts are refinanced at a lower rate than you currently pay. While this does not work in all cases, consolidation may provide a single, lower lump-sum payment that can help you pay off all of your debt faster.

Principal, Interest Rate and Loan Amortization Period

The principal is the amount of money you borrow from a lender, whether it is from a bank, credit union, car dealership or other loan agency. The interest rate is essentially the price of borrowing that money. The time you have to pay it back is known as the loan amortization period. If a lender loans you $20,000 to purchase a car and you pay the same amount back in five years, the lender makes no profit.

That is where interest factors in to the equation. The interest you pay on the loan represents the profit the lender earns on the money they lend you. With compound interest, that profit can be quite high, which explains the incentive lenders have to find as many takers for car loans as possible. A person who borrows $15,000 at 5.0 percent interest for five years pays back more than $4,100 in interest on top of the original $15,000.

Dropping Credit by Skipping Payments

As making payments has a strong positive effect on credit, skipping them has an even stronger negative effect. Skipping payments completely is unacceptable, and will result in very big drops in your credit score. A payment is usually considered skipped if it is more than 60 days late. If you make a late payment that is not very late, it is possible that the lender will extend a grace period and will not make note of the late payment to the credit bureau, so your credit won't be affected. Don't despair if your payment is only about a week late, and call your lender to explain the circumstances.

What Happens if You Default

Defaulting on a loan is, in short, not something you want to do. It will ruin your credit and the record of your defaulting will appear on your credit history for the next seven years - a long time to pay for one mistake. For more information about the consequences of defaulting on a car loan, click here.

When you borrow money to purchase a new or used car, the payback is structured for you to make regular monthly auto loan payments until the loan is paid off in full. The amount that you will have to pay back each month on your auto loan depends upon the principal of the loan, the interest rate on the borrowed money and on the number of months you have to pay it back.

The auto loan payments you make each month represent a portion of the principal plus interest. Find a simple online loan calculator to determine the monthly payment for a loan you are considering, and you can work the amount into your budget.

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