While grads work on paying off their debt, there’s a bright side for those who do so responsibly. The potential reward: a better credit score.
Here’s how student loans affect your credit score and how they can help your credit, especially when starting to establish a credit history.
Student loans help get a credit score
Getting the first line of credit is often the toughest. Even with student credit cards, approval isn’t guaranteed for young adults. The reason: banks are hesitant to lend to those with no credit history.
Student loans help solve this problem. Just as with other loans, student loan activity is sent to the credit bureaus. After having a student loan account open for at least six months and with activity reported within the last six months, students become eligible for a FICO score if they don’t already have one.
Federal Stafford and Perkins loans don’t require a credit check for eligibility, making them one of few loans those with no credit or bad credit can obtain. Students won’t have to prove creditworthiness or find a cosigner for these federal student loans, unlike credit cards or other lines of credit.
Paying off loans early won’t hurt your score
Student loans are no exception to credit myths. Several myths are related to the effects of paying off student loans early. But paying student loans off sooner is actually more likely to help credit in addition to saving money.
One myth: Paying off loans early will hurt your credit score because less interest is paid and banks don’t like this. This doesn’t matter, especially since interest payments aren’t reported to credit bureaus.
Another: Paying off loans early will hurt credit age, a factor in FICO scoring. Credit age is reported the same whether loans are active or paid off, so pay back loans early without fear of bringing down your score.
On-time payments greatly influence credit score
Payment history on payment accounts is often the most influential in terms of credit score, accounting for about 35% of the FICO calculation. Student loans count no differently than other loans or lines of credit. Making sure to pay on time is important to achieve credit score benefits.
Keep in mind: Forbearance and deferment won’t hurt your credit score as they’re servicer-approved options.
Even more helpful is that federal loans automatically come with several repayment options that can make on-time payments even easier. Student loan holders can lower payment amounts to avoid credit damage from falling behind on student loan payments.
Provide access to good credit mix
Diversity in the types of credit used accounts for about 10% of your FICO score. Keeping a good mix of credit can be difficult without taking on extra debt, especially for young adults. Student loans might give the best opportunity to young graduates to raise their score with credit other than credit cards.
Student loans are reported as installment loans while credit cards are considered revolving loans. These two types of loans are complementary when it comes to credit scoring.
Other installment loan options might not suit students as well. Students may not be looking to take out a mortgage immediately after college. Auto loans require buying a car, and the interest isn’t deductible like it is for student loans or a home mortgage.
Consolidating can help credit
Consolidating student loans may have some hidden benefits beyond simplifying paying off loans.
Having several student loan accounts with an outstanding balance can be bad for your credit score. When consolidating, student loans accounts are bundled into one, which can bring up your score.
Even if you don’t choose to consolidate, paying off accounts can have a positive effect. This gives you good reason to use a debt snowball or another approach to whittle down multiple accounts one after the other.
Having large amounts of debt might not be as harmful as you think, either. Since student loans are considered installment loans, the balance isn’t weighted as heavily into your credit score as it is for revolving debt, like credit cards.
Don’t over-estimate the benefits
The information above might sound like an endorsement for student loans, but don’t be fooled. Student loans are still debt, and with standard interest rates on federal loans at 6.8%, they’re far from a bargain.
Despite the credit score benefits student loans offer, I’m not advocating taking out loans to get these benefits. The credit benefits from student loans aren’t automatic, either. Student loans can harm your credit score if you’re not careful, as just one late payment can bring down your credit score. Student loan debt can affect the eligibility for loans like a home mortgage based on debt-to-income ratio.
(image: mer chau)