Credit Karma Answers: Should I Pay Cash for My Car or Finance?

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Question:

Seven years ago, thanks to my parents, I graduated from college with no debt and a healthy love of saving money and living below my means.

Over the past year, I saved for a new-to-me car and did a lot of research to get a great deal. When I went to buy, I could have paid for the car outright but decided to finance in order to build credit. I was surprised to find out that though my credit score was an excellent 778, I was going to be slapped with a high interest rate. The salesman doing the financing said banks were not interested in lending to me because a) I was a first time borrower, b) it was a used car, and c) my credit history consisted only of credit cards.

Though I negotiated it down a bit, the salesman recommended making the monthly payments for a year and a half before paying off the loan. He said that then, I would establish credit and be a more desirable borrower the next time I buy a car, or when I’m ready to buy a house.

Woman Getting New Car

I have a few questions. First, was the salesman being sincere about why the interest rate was so high? Second, since I could pay this off at any point, I’m wondering how long I need to make monthly payments in order to establish enough credit. Is it really a year and a half? And lastly, since my credit is already so good, is it even necessary to make myself a more desirable borrower?

Answer:

One thing’s for sure: You’ve made some great money moves so far. Good job! And you’re right, your excellent credit score ultimately serves to help access the best financial offers and save you money on interest rates. Now, to answer your questions.

Why is the interest rate so high?

First, the salesman is correct; you’re a higher credit risk because of your first-time borrower status and limited credit types. Second, it’s a loan through the dealership. These loans are historically inflated because most dealerships make more money from financing than from the mark-up on a car. (You can get loans from other sources; more on that below.) It’s also true that used car loans will come with a higher interest rate; however, it shouldn’t be more than 1-2% higher than a new car auto loan. The average interest rate for a 60-month loan on a new car is 4.58%, while a 36-month used car loan has an average rate of 5.36%, according to Bankrate’s latest numbers.

How long will it take to establish credit history with my auto loan?

If you choose financing over paying in cash, it will help build your credit rating as long as you pay responsibly and on time, but there isn’t a specific timeframe for this credit-building strategy. Keep in mind that the car salesman wants to get you to sign on the dotted line as quickly as possible. If he convinces you to choose the dealership’s financing and to make payments for a year and a half, he’ll get commission on the sale and the dealership will make money from the interest you’ll pay on their financing. In order to build your credit, it doesn’t matter what financing option you go with, dealership or through another lender, as long as you make timely payments.

How do I become a desirable borrower?

Having a diverse credit portfolio, such as having credit cards, student loans and auto loans in your name, along with making timely bill payments, is important in order for you to be seen as a desirable borrower. However, a good credit score should also save you money. Making timely payments on an auto loan will help you build your credit history, but taking on additional debt and paying a high interest rate for the sole purpose of becoming more creditworthy is counterproductive.

If you do decide to finance instead of pay in cash, here are some tips to help you in the process, and while you’re building your credit:

Shop Around

Instead of taking the dealership loan right away, spend some time researching other loan options first. With an excellent credit score of 779, you should be able to find better financing options with lower interest rates. Credit Karma shows you offers based on your credit profile. You can qualify for independent financing through a bank or a credit union before you head to the car lot.

If you plan to apply for several auto loan options, do it within a short amount of time; all of the hard inquiries from applying for several lenders should count as a single hard inquiry if they are initiated within a short timeframe, which means less damage to your credit score. Though there’s no standard for how short of a timeframe, you should be safe if you stay within a 30-day period.

Get a Cosigner

Find a trusted family member with good credit to cosign the auto loan for you. Both of your credit scores will work in tandem to get you a better rate on your new loan, which will cost you less on interest in the long run.

Find a High-Yield Savings Account

Once you buy your car, keep the cash you’ll be using for monthly payments in a high-yield online savings account for bonus interest earnings. While interest rates on savings accounts aren’t high right now, earning a little extra in interest earnings helps toward paying down your car. This is a great option for you, since you already have the cash saved up for your car.

Pay More Than Your Monthly Minimum

By doing so, you’ll speed up your loan repayment while also saving money on the interest. Plus, you’ll still get the credit-building benefits of the auto loan.

Bottom Line:

You have good credit: Put it to work for you so it saves you money. Having a good mix of credit is helpful, but it’s more important to make smart money choices.

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  • Greta

    Paying in cash for a car is always best. We are such a slave to the credit score.

  • Karen

    I know you said that there isn’t a “specific timeframe for this credit-building strategy”, but is there a recommended minimum amount of time for keeping a car loan to establish credit history? For example, would a credit rating company want to see at least 6 months of timely bill paying? Thank! 

    • http://www.creditkarma.com/ Bethy @ Credit Karma

      There is no firm minimum. Each month that your loan is open and in good standing, you’ll be building your credit. But as soon as you close or pay off the loan, those benefits will diminish over time. Therefore, you should only use financing if you need it; don’t pay interest just to build credit.

  • Katie the Carlady

    It is such a complicated credit system. In my experience of 18 years in the auto industry and helping people with credit, 12 to 18 months is what the banks look for on auto loan repayment history. That is what the indirect lenders say. Also if you do not have auto history and your a college grad, there are manufacturers that offer the low rates on new cars. Plus extra rebates for college grads also. Toyota, Nissan, Hyundai and Kia are a few. The dilemma with the credit score is that is does affect so much. If you agree to pay the higher rate, then just finance a smaller amount of money for the shortest term. Then you can minimize the interest.

  • http://www.rayskillmanchevrolet.com/section/secondary/buy-here-pay-here-cars-indiana-finance-specials Tyra Shortino

    A car buyer has two options when
    buying a car. If a buyer has more than enough to pay for the car in full, then
    that would be better. Otherwise, one can apply for a car loan instead, but he
    has to make sure to get one from a reputable bank at a reasonable rate of
    interest.

  • vivek sinha

    Thanks for your great information, the contents are quiet interesting.I will be waiting for your next post.
    Trade Car Sales in warrington,,,

  • slyaii

    car dealerships do not make money off the interest that you borrowed for financing, the bank does. the bank already pays the dealer in full for the car that you are financing. the interest that you are paying goes to the lender. the salesman already made the commision from the sales not from the interest charge over financing.