Sounds really counterintuitive, doesn’t it? Your credit isn’t all that good. So you should buy a new car? But it’s true. Buying a new car, getting a loan for it, and then making your payments on time every time is one of the best and quickest ways you can repair your damaged credit score and credit report.
Before you can understand how to build credit with an auto loan, however, you need to understand how the credit system works in Canada.
In Canada, credit scores range from 300 to 900. This range is broken down into several categories as follows:
- Excellent (741-900)
- Good (690-740)
- Fair/Average (660-689)
- Below Average (575-659)
- Poor (300-574)
As you might expect, the higher your credit score, the easier you will find it to get any kind of credit.
Credit Score Factors
Five separate factors go into your credit score in the following percentages:
- Payment history — 35%
- Credit utilization — 30%
- Length of credit history — 15%
- Soft and hard credit checks — 10%
- Credit diversity — 10%
Credit utilization means how much of your available credit you’ve actually used. Potential lenders like to see a credit utilization of 30% or lower. So if, for example, you have a credit card with a $10,000 credit limit, your balance on it should never exceed $3,000.
A soft credit check occurs when you check your own credit score or when someone else, such as a potential landlord, checks it for non-lending purposes. A soft credit check has no impact on your credit score. A hard credit check, however, does. A hard credit check occurs when a potential lender checks your credit score prior to giving you the loan, credit card, etc. If you have too many hard credit checks within a short period of time, this could knock your credit score down by 7–10 points because it indicates you could be having financial problems and are shopping for as much credit as you can get.
Credit diversity means the type of credit you have; i.e., installment versus open versus revolving.
In addition to your overall credit score, you also have a credit rating for each of your credit accounts. Each of your lenders gives you a credit rating for that particular account that consists of a letter and a number as follows:
- I means an installment loan for which you make a fixed monthly payment until a predetermined date.
- O means an open credit account for which you must pay the entire balance each month.
- R means a revolving credit account for which you must make monthly payments, but both the minimum payment and the balance likely varies each month.
- A number from 1–9 that represents how well you pay this bill.
Here, the lower your number, the better your payment history. For example, a 9 means that you never pay your bills on time, while a 1 means that you always pay them within 30 days of their respective due dates. Your new accounts carry a 0, meaning that they’re too new for you to have established a payment history.
How Buying a New Car Helps Your Credit
Now that you know how the Canadian credit system works, let’s get back to our original question. How can buying a new car help you build your credit?
As stated, a car loan is an installment loan. Consequently, if you currently have no installment loans, buying a new car helps improve your credit diversity, 10% of your overall credit score.
But the biggest way that a car loan can substantially raise your credit score has to do with your payment history once you get the loan. Car loans typically last for five years. Therefore, if you make each monthly payment on time, you can quickly establish an excellent payment history. And remember, payment history accounts for 35% of your overall credit score.