It’s no secret: buying a car takes money. A lot of money. Usually, a lot of money that you have to borrow. If your credit score is less than stellar, getting a big enough loan from the bank might not be so easy, and it may come with exorbitant interest rates that make the whole project seem beyond reach.
Fortunately, there’s another way to get the keys to a new car.
Leasing is a great alternative to buying. There’s a reason why it’s becoming so widespread and popular among drivers from all walks of life. By leasing, you may be able to avoid the hefty down payment and enjoy more reasonable interest rates. Best of all, leasing a car can actually help you improve your credit score.
Sounds like a win-win, yes? But how does this work? First let’s check out how creditors determine your score, and then we’ll see how leasing can be a big credit booster.
How do creditors determine your credit score?
Creditors look at several different factors to calculate your credit rating.
- Payment History
First comes your payment history. Creditors look over your whole payment record since your account was established to determine whether you have a history of paying your debts on time.
This payment history goes a long way in determining how risky you are as a borrower and how likely you are to keep up with your monthly payments.
Miss enough payments on your credit card (or utility bill, or car lease), and these red flags in your account will send your credit score down the tubes.
However, if you’ve taken care of all your bills in a timely manner for long enough, you’ll be rewarded with a higher credit score.
- Credit Age
Secondly, they take a look at the age of your credit. Generally speaking, most people in their early 20’s to 30’s do not have a long history of credit, because they got their first credit card when they got to college. But, sometimes your age has nothing to do with it, more so how long and established your credit history is. Either way, the length of your credit history has a big impact on your overall credit score, since the lenders have more information to make a decision off of.
The next thing creditors check is the age of your credit. This doesn’t necessarily have to do with your actual age. However, most people in their 20’s or 30’s don’t have a long history of credit, because they probably got their first credit card only when leaving the house.
The length of your credit history has a big impact on your overall credit score, since it gives the lenders more information to base their decision off.
A new account is considered riskier just because it’s more uncertain. But if you’ve been consistent with your payments over many years, and especially if you have successfully completed long-term contracts like big loans or lease contracts, your long history makes you a more attractive candidate.
- Credit Utilization
Next, lenders look at your credit utilization: how much credit you have versus how much you are using. For example, if your credit card limit is $3,000 and every month you are maxing it out, your credit utilization is inevitably going to be poor.
The banks want to see that you aren’t using your whole card limit every month. Ideally, you should stick to only a quarter of the allowance or less. This shows them you are not solely relying on your credit card to pay your bills, making you less of a risk to default on your payments.
- Credit Inquiries and Account Diversity
Creditors also look at your hard inquiries and the diversity of credit accounts or loans in your name. (I’ll talk more about account diversity farther on.)
Hard inquiries are made on your credit every time a loan or credit line decision is being made to help determine approval. For example, applying for a Walmart credit card is considered a hard inquiry, since creditors are seeing if you are in line for the amount of credit you are requesting.
You want to be careful about these hard inquiries, since they are taken as a sign of financial uncertainty. Whether you get approved or not, excessively applying for credit cards, loans, or anything major can put a ding in your credit score, dropping it 3-6 points per inquiry.
- Debt to Income Ratio
The biggest factor when it comes to credit is your debt-income ratio. This is calculated when you add up all your monthly debt payment, such as a car loan, student loans, mortgages, etc., and divide the total by your gross monthly income.
Obviously, having high debt compared to your income makes you more of a financial risk.
How Leasing A Vehicle Boosts Your Credit Score
Now that you’ve got an idea how your credit score is calculated, let’s look at your new lease and how it’s going to boost up that score.
The basic idea is that you want to prove to the creditors that you are responsible and financially stable. In other words, you’re ready and able to make payments on time. When you lease a car, you have an opportunity to prove this by making regular monthly payments, but at a more manageable rate than if you were paying off a loan for buying the vehicle.
Here’s why leasing a car helps your credit.
- Lower monthly payments make it easier to stay on top
When you sign the papers for a new car, whether to lease it or buy it, you are agreeing to pay a certain amount every month until the end of the contract. The relevant difference is that with a lease, you will usually pay less per month than if you finance the car to ownership.
Every time you miss a monthly payment, your credit score will take a hit. Every time you make one, it will stabilize or creep upwards. So the more you increase your chances of making every payment on time, the better for your score!
Already 35% of your score is based on payment history, so monthly car payments have the potential to really boost your credit. (Or drag it down if you’re not careful!)
If you take on a lease at a rate you can realistically afford, and you’re attentive to make payments on time, you’ll see your credit improve month by month. By the end of your contract, you should see a significant improvement in your score.
- Borrow less, be less of a risk for the bank
Along with your consistency in making payments, your amount of debt is an important factor that creditors look at. More debt means more risk for the bank. After all, they’re responsible for paying if you default.
Another advantage of leasing a car is that you borrow much less than you would need to buy a car in full.
If you buy, you’re on the hook for the whole price of the car. This can be a serious sum of money.
With leasing, however, you’re mostly paying off just the car’s residual value, or the amount it depreciates over the leasing period. This means you have way less debt in your name.
For example, you might owe $20k, $40k or more to buy a vehicle. The sky’s the limit when it comes to cars!
But for a lease, let’s say you are paying $250 per month over a 36-month lease term. This comes to only $9,000. It’s a big difference, and it makes you a much safer bet for the bank.
- Installment accounts add valuable diversity to your credit profile
Also, your lease will show up as an “Installment Account” on your credit report, and that alone can improve your score. Simply increasing the variety of the type of credit you hold helps push that score up.
Your lease will show up on your credit report as an installment account, which alone can improve your score.
If you’re not familiar with these credit breakdowns, know that not every charge to your bank account is the same. There are three basic categories of payments that creditors recognize:
- Revolving accounts, such as credit card payments. These demand a different payment every month and are not required to be paid in full at the time. Whatever you don’t pay will “revolve” or carry over to the next month.
- Installment accounts, such as your car payments. These are a set payment every month. They may also be carried over to the next month, but for your credit score it’s more important to settle them at the time.
- Open accounts, such as for utilities or a charge card. These will require a different payment every month, but they must be paid in full by the end of each billing cycle.
Creditors like to see diversity in your record. In fact, just the type of credit you use accounts for 10% of your FICO score. So if you only have revolving and open accounts, as many people do, adding an installment account is already a boost.
- Demonstrate long-term reliability
Banks, much like your significant other, want to see that you’re good for a long-term commitment.
In fact, 25% of your score has to do with the length of your credit. Having a lease contract on your record is a simple way to show you’re in for the long haul.
A typical lease period is 24 or 36 months, or even 39. By the end of this time, if you’ve kept up with your payments you should see a big improvement in your credit score. Showing this completed contract over such a long period will demonstrate how reliable you are, making you a much more attractive candidate for future loans.
A common complaint from people with bad credit is that they can’t get approved for a lease, or only get offered contracts with huge down payments or crazy interest rates.
However, there is a way around this: find a guarantor to co-sign on your lease. A guarantor is someone with good credit who agrees to take responsibility for your lease in case you aren’t able to pay.
With a guarantor, you will be eligible for all the lease deals that they can get with their high credit score. This may include zero-down lease offers and low interest rates that make it much easier for you afford a lease, which in turn is an opportunity to improve your credit to the point where you can get approved for a good lease on your own next time.
Since co-signing a lease is a serious commitment, your guarantor must be someone who you trust completely and who likewise trusts you.
Can leasing a car hurt your credit?
I don’t want to make it seem like leasing a car is a silver bullet that will magically wipe away all your credit woes.
As I mentioned before, if your credit is really bad, you might not be able to even get approved for a lease, unless you have a guarantor to co-sign with you.
A lease is another debt on your account, which reduces your credit. It might be much less of a debt than if you were buying a car, but still more than if you’re taking the bus. And unlike a car you’re financing to own, your lease car is considered a liability rather than an asset. (It’s a monthly expense and a risk that you and the bank are responsible for, but you don’t get to own it.)
And of course, if you miss payments or (worst case scenario) have to end the lease early, your credit will take a hit.
The world of credit can seem like a maze of numbers and mysterious calculations, but improving your credit doesn’t take rocket science. There aren’t any quick fixes, but if you play your cards right, over a few months or years you can boost your credit score to the point where your whole financial outlook is changed.
Leasing a car, although it comes with risks, is a very effective way to boost your credit, while at the same time you get yourself a new car to drive! Especially if your credit is very low, co-signing a lease with a guarantor allows you to pull yourself up by your bootstraps and set yourself up for financial stability.