How to Finance Your Car to Help Build Credit

Financing your car can help build your credit. Because of the very large price tags on most cars, most people require some financing in order to purchase one. Such financing typically comes in the form of a two- to five+-year installment loan.

Anyone lending you money to buy a car receives and reports credit bureau data. When lenders go on the hook for that much money, they want to be sure that you’ll make your payments, even if you get in a cash squeeze. Most car loans are secured by the car.

If you’re debating using equity in your home to purchase a car, be careful. Using a home-equity loan to buy a car may offer a tax advantage, but it may increase the risk of a home default and subsequent foreclosure if you can’t make the extra payment. If you default on that home-equity loan, your car won’t be repossessed; instead, and much worse, your home may be foreclosed on.

Plus, any mortgage debt forgiven in a short sale or foreclosure may be subject to income taxes. Although the Mortgage Forgiveness Debt Relief Act eliminates taxes due on forgiven mortgage debts, it excludes non–house-related debt.

Be sure to pay off the loan you used to buy your old car before you buy your next new one! Some people keep old car loans on their home-equity lines long after the cars are gone and keep adding new balances without paying off the old ones. Doing so can lead to an unpleasant surprise when interest rates go up or you need to sell your home.

Weighing the pluses and minuses of leases

Leasing is a popular way to get a car. You don’t own the car in a lease arrangement. Consider a lease a long-term rental. Leases are popular because they generally require only a small down payment. Plus, they’re a tax write-off if you’re a businessperson. Signing the lease commits you to a stream of payments for an extended period, so this activity is normally reported to the credit bureaus.

Leases are difficult and costly to terminate. Unlike with a car loan, you can’t sell the car and pay off the loan. With a lease, you owe all the payments, and you can’t terminate the lease without making all the payments first. However, an active-duty serviceperson who is called away for military service can break a car lease.

Steer clear of upside-down loans

The term sounds as uncomfortable as it is. Basically, in an upside-down loan, you owe more than the value of the item securing the loan. Avoid being upside-down in a car loan, or any secured loan (upside-down home mortgages work similarly), if you can help it. A repossession or default is a negative on your credit report and causes your score to fall — hard!

An upside-down loan can hurt you when you want or need to sell the car and stop making payments. Say you owe $10,000 on a car loan, and the value of the car is $7,000. You have to come up with the $3,000 difference or you can’t sell the car. If you’re in an accident and the car is totaled, the insurance company pays only what the car is worth.

This situation gets worse if your financial situation changes, you can’t make the payments on the car, and the creditor repossesses the car. The car is worth $7,000, but that’s the retail value. The lender is likely to sell the car at auction, where the creditor gets only $5,000.

Among the towing guy, the attorney, and the sales commission to the auctioneer, the fees on the repossession are $2,000. So you are credited with $3,000 against the $10,000 you owe. Now you owe $7,000 in a lump sum to settle your account, you have no car, and you have bad credit.

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