Buying a car is a big financial decision, but does a vehicle purchase mean you have revolving debt? Debt is a complicated subject, so we’ve researched in-depth to find the best answer to the question of how car loan debt works. Here’s what we’ve uncovered.
Car loans are not revolving debt. A car loan is a type of debt, but only credit-type accounts are revolving debt, allowing you to run up a bill, then pay it down again. Credit cards are a prime example of revolving debt.
While credit cards are one kind of revolving debt, there are others, too. And there’s more to learn about car loans and revolving debt, so read on for all the facts.
What is Considered Revolving Debt?
Revolving debt works a lot as it sounds—the balance “revolves,” or changes, depending on how you spend. But this type of debt refers solely to credit cards. Revolving credit, as it’s also known, involves a borrower running up a balance, then paying it down.
Over time, your debt revolves, hopefully down to a zero balance. Another type of revolving credit is a home equity line of credit (HELOC), but other types of debt are monthly installments—such as mortgages and car loans.
Is a Car Loan Considered Debt?
Because you’re borrowing cash from a financial institution to pay for your car, the loan you get is considered debt. You’re paying off the value of the vehicle plus interest and any fees the lender charges. But there are different types of debt, and car loans are secured loans. If you don’t pay on the vehicle, the lender can repossess it—they’re securing the loan with the car.
Car loans are generally fixed monthly payments at an agreed-upon interest rate. The higher your down payment is at the time of purchase, the lower your remaining debt on the car loan. Of course, knowing whether car loans are amortized also impacts the bottom line—and your monthly payment.
But the bottom line is that a car loan is debt, and typically a long-lasting one. Most vehicle loans range from 36- to 72-month terms. And car dealerships may prefer that you use a loan rather than cash since it’s a better deal for them. But six years (or more, in some cases) is a long time to pay down an installment debt.
How Car Loans Impact Debt to Income Ratio
It’s important to note that because a car loan is considered debt, your minimum monthly payment impacts your debt to income ratio. A debt to income ratio is the figure many lenders use to determine whether you can afford the financial product you want.
A high debt to income ratio—meaning you’re spending a lot on car payments, a mortgage, credit cards, and other debt—makes you a more significant risk to lenders of all types.
Is Installment Debt Better Than Revolving Debt?
The question of whether installment or revolving debt is better depends on multiple factors, such as the balance you owe, the credit you have available, your total debt to income ratio, and more.
Installment Debt vs. Revolving Debt Balances
The deciding factor on whether installment versus revolving debt is better might be the balance amount.
If you have a low balance on an installment type loan—such as a vehicle loan—it will only get smaller, boosting your credit score over time. But revolving debt can fluctuate, meaning the balance can get either higher or lower based on your spending habits.
At the same time, an installment debt with a higher balance doesn’t always reflect well on your credit score. The good news is that the payment is typically predictable each month, and you’ll eventually pay it off entirely.
Credit Utilization Ratio
Another factor to consider is your credit utilization ratio. This is a figure that applies to credit cards only and divides your total balance by the available credit you have.
So, if your credit card has a $1,000 limit and you have spent $500, your credit card utilization rate is 50 percent. To most credit agencies, a 50 percent utilization credit is high. Ideally, lenders want to see a utilization ratio under 30 percent, and that can help enhance your credit score.
In contrast with credit card revolving debt, installments aren’t calculated with a utilization ratio. The odds are that your balance will keep dropping as you pay. As long as you don’t miss a payment, your credit should go up.
Debt to Income Ratio
A good thing about revolving debt is that you can pay it down over a month or a few months. And while it’s possible to pay off a car loan early, the odds are that you won’t make a dent in the balance for at least a year or more.
Therefore, revolving debt can be better for your debt to income ratio because you can lower the balance. With an installment option like a vehicle loan or mortgage, your monthly payment is set—so it factors into the debt to income ratio calculations until you pay it off entirely.
If you’re applying for a financial product like an auto loan and need to submit pay stubs, the lender will take your current debt and divide it by the monthly income on the stub. If your credit card balance is suitably low, you may qualify for an auto loan easily.
But if the balance is high, you might not qualify—until you pay down the revolving credit account to an acceptable level. Make sure you read this post about whether you need paystubs for an auto loan before you head to the sales lot.
Do Revolving Accounts Hurt Your Credit?
A revolving account can hurt your credit in a few different scenarios.
What Happens When You Use Too Much Credit?
You might see a ding on your credit score when your balance increases to over 50 percent of the available credit. Regardless of your debt to income ratio or your income in general, high credit card utilization shows that you’re not living within your means.
Instead, you’re racking up debt—and that suggests to lenders that you’re a credit risk. Plus, the higher the balance on a revolving credit account, the more you’ll pay in interest. As long as you’re carrying a balance on the card—and you’re not within a promotional period, such as with a zero APR—you’ll be paying interest.
Maxing Out Credit Cards Hurts Your Score
If you stretch your credit card to the maximum available amount, that could also result in a plunging credit score. In general, maxing out any account has the potential to make your score plummet. Keeping your balances low—or paying them off before the bill is due—is the best way to protect your credit while utilizing revolving debt options.
Are you wondering how your credit score will impact a lending decision? Read this post on whether lenders look at Equifax versus TransUnion when pulling your credit.
Consequences of Paying Late
Paying late will also result in fees and a lower credit score. Keep in mind that depending on the card’s APR, a higher balance likely means higher monthly payments. If you can’t make a payment, your credit will dive as soon as the lender reports it.
Do Revolving Credit Applications and Account Closures Affect Credit?
Multiple applications for revolving accounts are another tick against you on creditworthiness decisions. Closing a credit card can also negatively affect your credit, so it’s recommended to keep them open. Putting a single, small bill on your open card each month, then paying it off, can help your credit while avoiding dips due to account closures.
If you use it wisely, revolving debt can be an important part of your overall credit profile. Your credit score is calculated based on a handful of factors—and open and responsibly used revolving credit accounts are typically a benefit.