Editorial Policy

Getting the Best Car Loan with Damaged Credit

Eva Norlyk Smith Ph.D.

January 2, 2013

QHi Eva,

I’ve pretty much nursed my credit back to health the past year and a half. My FICO score is 650. To do that, I got a card with a very low credit limit ($500) and a monthly servicing fee of about $7. I just got approved for a much better card with a higher limit ($3,000) and no fees. I want to cancel my old card ASAP to avoid the monthly fee.

Well, my car suddenly died a couple weeks ago, and I need to get a new one. My brother is letting me use his car in the meantime to let me save up for a down payment. I’ve been saving like crazy and should be ready to get a car in three months (that’s my goal). Would canceling that old card now hurt my credit and ruin my chances of getting a good car loan? I want to cancel that card sooner rather than later (even $7 is a big deal to me because I’m on such a tight budget), but if I have to, I can wait a few months. What do you think I should do? – Joy

ADear Joy,

Congrats on getting your credit score back on track! It’s encouraging that you’ve been able to improve your score in as little as 18 months. Sounds like you’ve picked up some good financial management habits along the way.Ask Eva

You are completely right — a $7 monthly fee is a lot to pay for the pleasure of having a credit card with a $500 credit limit. Unfortunately, I’ve got bad news for you: You will have to hold on to that card just a little longer.

Here’s why: While you’ve obviously made a lot of progress, you’re not done rebuilding your credit score. A FICO score of 650 is still borderline, and while it will qualify you for a car loan, you’re a ways away from excellent credit, which will get you the very best loan rates. This requires a FICO score of 720 or higher.

The good news is that you could get much closer to or reach that 720 goal over the next couple years. To do so, you’ll need to stack as many factors as possible in your favor. Right now, the credit card with the $500 limit is your oldest credit card, and you have no other credit card with a long positive payment history. So, canceling that card will indeed ding your credit score. It may not be a huge effect, but it’s the last thing you’ll want just before taking out a car loan.

A FICO score of 650 is in the low range of what’s acceptable for a car loan, and it won’t get you the best interest rates. To find out where you stand, check out this Autoloan Estimator from myFico.com. As you can see, for a 36-month auto loan, for someone with a credit score between 620 and 659, the average interest nationally is 10.42 percent. If your FICO score were to increase by just 10 points to 660, you should be able to qualify for a rate of 6.95 percent, an almost 4 percent drop.

On a $10,000 loan held over 36 months, that’s a considerable savings in interest. At the 10.42 percent rate, you’d pay $1,687 in interest over the life of the loan. Get the 6.95 percent rate, and the interest paid drops to $1,107. In other words, a 10-point increase in your FICO score could save you $580 in interest over three years.

If you were in the top range of FICO scores with a score of 720, the average loan interest rate would be 3.45 percent on that 36-month loan, and total interest paid drops to $540, saving you $1,147 over the life of a loan.

In short, sprucing up that FICO score before taking out a car loan can save you big money. While a $7 monthly credit card fee is annoying, in your case, it’s worth paying to save more in the long run. That doesn’t mean that you have to hold on to that $500-limit credit card forever, though. Here are your best options to improve your score and get the best long-term rates on a car loan.

  1. Keep the credit card with the $7 monthly fee for at least six months longer, preferably a year. That will give you time to build up a positive payment history on the other credit card and make that work for you.
  2. Save up as much as you can for the down payment on the car. During that time, use the new $3,000 card actively, but be sure to pay off the balance in full each month. The higher credit limit will help your score, as will having two active credit card accounts.
  3. Keep track of your credit score during this time, and, assuming your brother will let you borrow his car a bit longer, wait to apply for a car loan until your credit score gets above 660. With the added credit card, it should be only a matter of time before your score inches up. You can use this free FICO Score estimator from Bankrate.com if you don’t want to pay for a service (such as MyFICO.com) to get copies of your FICO score. Once your score is above 660 and you have saved enough money for the down payment, go ahead and apply for that car loan.

Once you have your car loan, call the issuer of your $500-limit credit card and explain that your credit score has improved. Ask if you could be switched to a no-fee credit card. Explain that you’d like to continue to do business with the issuer and that the alternative is to cancel your account. Check out the card options for people with good credit offered by that card issuer, so you know which credit card you might qualify for. If the issuer agrees, also ask for a card with a higher credit limit. Your issuer may or may not go for it, but there is no harm in asking. If you aren’t offered any better options, just go ahead and cancel the card.

In the long run, the car loan will improve your credit (as long as you make payments on time) because it adds to your credit mix. To further improve your score over time, you might also consider taking out one more credit card so that you end up with a total of two to three credit cards (of course, don’t do this if it tempts you to spend more). Finally, once your score is over 720, consider refinancing that car loan to benefit from the extra interest savings. With time and patience, you will come out well ahead in the long run.

Got a question for Eva? Send her an email.