Understanding Your Finances
Banks, including those owned by automakers, are tight-lipped about who can qualify for the lowest-interest loans. But in general, those loans are only offered to their best customers — those with the highest credit scores.
Before you sit down to figure out your credit status, make sure you also understand your budget. How much of a monthly payment can you afford? Have you taken insurance payments into account? What about fuel prices and other upkeep?
"It's good advice for consumers to know what their credit score is before applying for a loan for something as big as a car."
Don't underestimate ownership costs when trying to determine your budget. Research insurance prices for both the vehicle segment and the specific car you're interested in with Allstate, State Farm or other providers.
After that, it's time to learn about your credit rating. The credit scores that banks look at are based on ratings from the Fair Isaac Corp. (FICO), which provides a mathematical formula that ranks your credit worthiness against that of other borrowers. Your rating is based on your credit history at the three major credit bureaus — Experian, Equifax and TransUnion. FICO scores are the most widely used credit scores, with more than 70 percent of the largest 100 U.S. financial institutes using them.
Credit scores range from 300 to 850 — the higher the better — and they directly reflect your credit risk to lenders. For example, Fair Isaac assigns a 1 percent risk of default to those with a credit score of 800 or better, a 2 percent risk for 750 - 799, and a 5 percent risk for those between 700 and 749. Consumers with the higher risk of defaulting have to pay higher interest rates.
It's important to note that the FICO scale is not a bell curve. Just because you have a credit score at the high end of the scale doesn't mean you have above-average credit. Most consumers have scores in the 700 range.
"If you have [a credit score of] 700 or higher, you can be confident of qualifying for the best rates," says Fritz Elmendorf, vice president of communications for the Consumer Bankers Association. "If you're below 680, you're going to have trouble qualifying for the best rate. But you should still shop for the best rate you qualify for," he says.
Many different factors affect your credit score. According to Ryan Sjoblad, public relations manager for Fair Isaac, the top five are:
- Your payment history. Even one payment more than 90 days late will lower your score.
- How much you owe. This is determined as a percentage of how much credit you have available.
- The length of your credit history. Fifteen years of steady payments is a lot better than 15 months.
- New credit inquiries. Every time you apply for a new loan or charge account, your score drops 10 points. These new inquiries drop off your report after six months. Multiple inquiries for the same installment loan (for example, when shopping for a car loan) don't lower your score any further, however.
- The mix of credit you use. When comparing revolving credit (credit cards, checking account reserve credit, etc.) and installment loans (mortgages, car loans, etc.), installment credit is preferable.
What doesn't matter is your income. As long as you keep paying your debts on time, income does not affect your credit score. But that doesn't mean lenders won't consider it in their lending process.
Each lender sets its own credit standards, part of which are FICO scores. These sometimes translate into the "tiers" that are advertised on low-interest finance deals. Tier 0 credit may offer the lowest financing rate, Tier 1 will be slightly higher, and so on. Your income and savings are also considered in order to determine your interest rate. There's no universal formula, but several websites, including Bank Rate Monitor, E-Loan and LendingTree, offer tables and calculators for rough comparisons.
"It's good advice for consumers to know what their credit score is before applying for a loan for something as big as a car," says Elmendorf.
To find out your credit score, visit Fair Isaac's website.
It's important to note that some 13 million inaccuracies occur on credit reports each year, according to Consumer Reports. These can range from omissions of good payment histories to omissions of late payments to cases of identity theft. These errors must be corrected with the individual credit reporting agencies.