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Financing a car can help you build credit, as long as you manage the loan responsibly and the loan’s activity is reported to one of the major credit bureaus.

Like with most other debt obligations, responsibly making on-time payments can help your credit score. However, making late or missed payments can hurt your credit score, as can the hard pull of your credit report that potential lenders conduct when you apply for an auto loan.

How Does Car Financing Work?

While it is possible to pay for a new car with cash, it’s common for many potential auto buyers to use car financing. You may get a car loan for the full purchase price, or make a down payment and get a loan for the rest of the amount.

The lengths of car loans vary but are commonly between 24 and 96 months, with six years (72 months) being the average. After making your payments for the balance of the loan, the loan is paid off and you take full ownership of the car.

Note that your car acts as collateral for an auto loan. This means that if you fail to repay the amount borrowed, the lender can take your car to recoup its losses.

Recommended: When Are Credit Card Payments Due?

How Financing a Car Can Affect Credit Positively

Most car loans are reported to the major credit bureaus, and your payment history and balance is usually included on your credit report. Making on-time payments on your car loan can have a positive impact on your credit. Potential lenders want to see a history of reliably paying your debts, and making payments on a car loan can help with establishing that.

Another factor that makes up your credit score is having a healthy mix of different types of credit. This can be another reason why having an active auto loan can help build credit, as it adds to the types of credit you have.

How Financing a Car Can Affect Credit Negatively

Just as making on-time payments on your car loan can have a positive impact on your credit score, missed or late payments can affect your credit negatively.

Additionally, when you initially apply for an auto loan, the lender will conduct a hard pull on your credit report to verify your creditworthiness. This can drop your credit score by a few points, though those drops usually only last a few months. If you’re working with multiple lenders, keep in mind that hard credit pulls by multiple lenders in a short period of time will usually get combined so it appears as a single inquiry.

And while paying down debt is often a good idea, paying off a car loan affects your credit in some additional ways. If you don’t have other debts or loans, it’s possible that paying off your loan can have a negative impact on your credit score. This is because your on-time payments no longer get reported, and you’ll have one fewer type of credit to your mix. Additionally, if you took out your car loan a while ago, paying it off can impact the average age of your open accounts, which also influences credit.

Factors That Influence Your Credit Score

The biggest factor that influences your credit score is your payment history. Potential lenders want to see that you reliably pay your debts, and making on-time payments is one way to show that. Other factors that influence your credit score are:

•   Your average age of accounts

•   Credit mix

•   How much you owe

•   How many recent inquiries appear on your credit report

Tips to Build Your Credit Score

Here are some tips to consider that can help build credit:

•   Make sure that you always pay your bills on time.

•   As you apply for new debt or credit, only apply for loans that you know you have the financial ability and discipline to pay.

•   Aim to keep your credit utilization — the amount of your total credit you’re using — at 30% or lower. Having a higher credit utilization rate can negatively affect credit.

•   Remember to check your credit report at least once a year. Not only can this help you to monitor your credit health and understand the impacts of various activities on your credit, it can help you spot any errors or fraudulent activity.

Recommended: Credit Score Needed to Buy a Car

Mistakes to Avoid When Financing a Car

One of the biggest mistakes that you can make when financing a car is applying for a higher loan amount than you can afford. When you take out a car loan, you’re making a multi-year commitment to make those monthly payments. If you take out a loan for more money than you can reasonably afford, you run the risk of destabilizing your overall financial situation and ending up in a situation where you make late payments or, even worse, miss payments.

Recommended: Average Payment for a Car

Is a Car Loan a Wise Option to Build Credit?

A car loan can be a good option to help build your credit. Remember, what potential lenders are looking for when they look at your credit report is a history of meeting your debt repayment obligations. A car loan that you regularly pay on time can be a great way of showing that you are reliable.

Also follow additional tips for getting a car loan to help give you a head start toward building your credit.

Other Ways to Build Credit

Aside from turning to car financing to build credit, here are a few other ways to build credit that you might consider.

Become an Authorized User

Another way that you can build credit is by becoming an authorized user on someone else’s credit card account. When you are an authorized user on a credit card account, you’re not financially responsible for paying the statement, but it still shows up on your credit report. Keep in mind that how the primary account holder manages their account can affect your credit score, either positively or negatively.

Recommended: Breaking Down the Different Types of Credit Cards

Consider a Personal Loan

Another option to build credit is by taking out a personal loan. Unlike a car loan, which is considered a secured loan since the car itself acts as collateral for the lender, a personal loan is an unsecured loan. That means that there is no collateral for the lender to seize if you stop making payments.

In certain situations, this can make a personal loan a great option for building credit. In fact, if an auto loan isn’t the right option, you can consider getting a personal loan for a car.

Apply for a Credit Card

Responsibly using a credit card and paying it off in full each month is another way that you can establish credit. Your credit card balance and payment history are typically reported to the major credit bureaus.

Additionally, some credit cards offer rewards, such as cash-back rewards, with each purchase. Those rewards can be a boost to your monthly budget.

Recommended: Does Applying For a Credit Card Hurt Your Credit Score?l

The Takeaway

If you take out an auto loan to buy a new or used car, it will typically get reported to the major credit bureaus. That means making on-time payments on your auto loan can help you build credit. Similarly, late or missed payments can have a negative impact on your credit score.

Applying for a credit card and making regular payments can be another way to build your credit.

Whether you're looking to build credit, apply for a new credit card, or save money with the cards you have, it's important to understand the options that are best for you. Learn more about credit cards by exploring this credit card guide.

FAQ

Does paying off a car loan help build credit?

While making regular payments on your car loan helps you build credit, paying off your car loan doesn’t always have the same impact. When you pay off your car loan, you no longer have the monthly payment history showing up on your credit report. Still, paying off a car loan can be a good financial move since it helps lower the total amount of your debt.

How can I keep my payment within my budget when financing a car?

The monthly payment amount of your car loan will depend on a variety of factors — the total purchase price of the car, your down payment, the length of the car loan and your interest rate. If you want to keep your monthly payment below the average payment for a car, you can get a cheaper car, make a higher down payment, or take out a longer loan. You can also work on building your credit score to hopefully qualify for a lower interest rate.

How fast can a car loan raise my credit score?

While taking out a car loan can possibly build your credit, you shouldn’t count on an immediate positive impact. In the short-term, it’s possible that your credit score may decrease from the new credit inquiries and the additional debt that shows up on your credit report. However, over time, making regular and on-time payments on your auto loan could build your credit score.

Does leasing a car build credit?

Most lease payments are reported to the major credit bureaus. That means that regular, on-time payments can help you build your credit in a similar manner to buying a car with a car loan. However, if you make late payments or miss payments on your lease, it can have a negative impact on your credit score.

Photo credit: iStock/Zorica Nastasic

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®

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What Is Extrinsic Value?

Extrinsic value is the difference between an option’s market price, known as the premium, and its intrinsic value.

Extrinsic value reflects factors beyond the underlying asset’s price that can influence the overall worth of an option. This value fluctuates based on the time to expiration and the volatility of the underlying asset.

Understanding Intrinsic and Extrinsic Value

The intrinsic value of an option is the difference between an option’s strike price and the current price of the underlying asset, which can be calculated only when the underlying asset is in the money. An out-of-the-money option has no intrinsic value.

Remember, an option that is “in the money” would be profitable for the owner if exercised today, while an option that is “out of the money” would not.

An out-of-the-money option may present an investment opportunity for some, however, because of its potential to become in-the-money at expiration.

Extrinsic value equals the price of the option minus the intrinsic value. As an option’s expiration approaches, extrinsic value usually diminishes since there is less time for the price of the underlying asset to potentially move in a way that benefits the option holder (also known as time decay).

For example, an option that has two weeks before expiry typically has a higher extrinsic value than one that’s one week away. This does not imply it has more intrinsic value, however. It just means there is more time for it to move up or down in price.

Out-of-the-money option premiums consist entirely of extrinsic value, while in-the-money options have both intrinsic value and extrinsic value. Options that trade at-the-money might have a substantial proportion of extrinsic value if there is a long time until expiration and if volatility is high.


💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

How Extrinsic Value Works

Simply put, the more time until expiration and the more a share price can fluctuate, the greater an option’s extrinsic value. Extrinsic value demonstrates the time that remains for potential price movement, and the uncertainty in that movement. There are a few different factors that could influence extrinsic value, and understanding them is crucial for evaluating an option’s pricing.

Factors that Affect Extrinsic Value

Two key factors affect an option’s extrinsic value: contract length and implied volatility. In general, the longer the contract, the greater the extrinsic value of an option. That’s because the more time allowed until expiration, the more a stock price might move in favor of the option’s holder. It’s possible, however, that the price moves in the opposite direction; if the holder keeps the option in the hope that the price will rebound, they may lose some or all of their investment.

The second factor that determines extrinsic value is implied volatility. Implied volatility measures the expected magnitude of how much a stock might move over a specific period. Volatility impacts an option’s extrinsic value, and its sensitivity is represented by the Greek letter vega.

Recommended: Understanding the Greeks in Options Trading

1. Length of Contract

An option contract generally has less value the closer it is to expiration. The logic is that there is less time for the underlying security to move in the direction of the option holder’s benefit. As the time to expiration shortens, the extrinsic value decreases, all else equal.

To manage this risk, many investors use the options trading strategy of buying options with varying contract lengths. As opposed to standard option contracts, a trader might choose to buy or sell weekly options, which usually feature shorter contract lengths.

On the opposite side of the spectrum, Long-Term Equity Anticipation Securities (LEAPS) sometimes have contract lengths that measure in years. Extrinsic value could be a large piece of the premium of a LEAPS option.

Some traders will also use a bull call spread, in order to reduce the impact of time decay (and the loss of extrinsic value) on their options.

Recommended: A Beginner’s Guide to Options Trading

2. Implied Volatility

Implied volatility measures how much analysts expect an asset’s price to move during a set period. In general, higher implied volatility means more expensive options, due to higher extrinsic value. That’s because there is a greater chance a stock price could significantly move in the favor of the owner by expiration (or out of favor if the markets shift in the opposite direction). High volatility gives an out-of-the-money option holder more hope that their position will go in-the-money.

So, if implied volatility rises from 20% to 50%, for example, an option holder may benefit from higher extrinsic value (all other variables held constant). On the flip side, an out-of-the-money option on a stock with extremely low implied volatility may have a lower chance of ever turning in-the-money.

3. Others Factors

There is more than just the length of the contract and implied volatility that affect the premium of an option, however.

•   Time decay: The time decay, or the rate at which time decreases an option’s value, can greatly impact the premium of near-the-money options, this is known as theta. Time decay works to the benefit of the option seller, also known as the writer.

•   Interest rates: Even changes in interest rates, or rho, impact an option’s value. A higher risk-free interest rate pushes up call options’ extrinsic value higher, while put options have a negative correlation to interest rates.

•   Dividends: A stock’s dividend will decrease the extrinsic value of its call options while increasing the extrinsic value of its put options.

•   Delta: An option’s delta is the sensitivity between an option price and its underlying security. In general, the lower an option’s delta, the less likely it is to be in-the-money, meaning it likely has higher extrinsic value. Options with higher delta are in-the-money and may have more intrinsic value.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Extrinsic Value Example

Let’s say a trader bought a call option through their brokerage account on shares of XYZ stock. The premium paid is $10 and the underlying stock price is $100. The strike price is $110 with an expiration date in three months. Also assume there is a company earnings report due out in the next month.

Since the share price is below the call’s strike, the option is out-of-the-money. The option has no intrinsic value because it is out-of-the-money. Thus, the entire $10 option premium represents extrinsic value, or time value.

As expiration draws nearer, the time value declines, also known as time decay. A trader who takes the long position with a call option hopes the underlying asset appreciates by expiration.

An increase in volatility, perhaps due to the or another catalyst, might push the option’s price higher. Let’s assume the stock has risen to $120 per share following strong quarterly earnings results, and the call option trades at $11 immediately before expiration.

The call option’s intrinsic value is now $10, but the extrinsic value has declined to just $1, in this scenario, since there is little time to expiration and the earnings date volatility-driver has come and gone. In this case, the trader can sell the call for a small profit or they might choose to exercise the option.

Note that if the stock price had instead fallen below the strike price of $110, the call option would have expired worthless and the trader would have lost the premium they paid for the option.

Extrinsic vs Intrinsic Value

Extrinsic value reflects the length of the contract plus implied volatility, while intrinsic value is the difference between the price of the stock and the option’s strike when the option is in the money.

Extrinsic Value and Options: Calls vs Puts

Both call options and put options can have extrinsic value.

Calls

Extrinsic value for call options can be high. Consider that a stock price has no upper limit, so call options have infinite potential extrinsic value. The more time until expiration and the greater the implied volatility, the more extrinsic value a call option will have.

Puts

Put options have a lower potential value since a stock price can only drop to zero. Thus, there is a limit to how much a put option can be worth, which is the difference between the strike price and zero. Out-of-the-money puts, when the stock price is above the strike, feature a premium entirely of extrinsic value.

Recommended: Understanding the Greeks in Options Trading

The Takeaway

Understanding the fundamentals of intrinsic and extrinsic value is important for options traders. Although intrinsic value is a somewhat simple calculation, extrinsic value takes a few more factors into consideration — specifically time and volatility of the underlying asset. The more time until the contract expires, and the more a share price can fluctuate, the greater an option’s extrinsic value.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

FAQ

Which options have the most extrinsic value?

At-the-money options typically have the most extrinsic value since their price is closest to the strike price, thus being most sensitive to changes in time and volatility.

Can an option’s extrinsic value be negative?

No. Extrinsic value represents the portion of an option’s price beyond its intrinsic value, so it can never be less than zero. If an option’s market price is lower than its intrinsic value, it can only be as low as zero.

Photo credit: iStock/alvarez