Financial decisions you make as a young adult can have long-term effects on your financial well-being. One of the most common debts to hover over your life for decades is student loans. It's important to understand how student loans impact your credit score if you want to avoid letting them take over your financial standing. While they can certainly hurt your credit score, they can also—believe it or not—help improve your score if you manage them wisely. Let's look at the different ways in which student loans affect your credit score.
How your credit score is calculated
The first thing you need to understand is how your credit score is calculated. It's determined by weighing 5 major categories. The 2 largest categories are payment history (which accounts for 35% of your FICO® Score) and amounts owed (which makes up 30% of your FICO® Score). Your payment history is based on whether you have consistently paid at least the minimum monthly payment required for all of your accounts on time. The amounts owed category takes into consideration the amount you currently owe, as well as how much credit you have available.
The remaining 3 categories include length of credit history (15%), new credit (10%), and type of credit used (10%). Your credit score favors accounts that have been open and in good standing for a longer period of time versus newer accounts. New credit can adversely affect your credit score, especially if you have a large number of credit applications within a short time period, indicating that you may be a risky borrower. Finally, lenders want to see that you can manage a diverse mix of credit, such as revolving credit (credit cards) and installment loans (student loans).
When student loans increase your credit score
Most people assume student loans can only hurt your credit score when, in fact, they have the potential to increase your credit score in some circumstances.
On-time monthly payments
Many monthly obligations, like rent and utilities, will not appear on your credit report unless you become delinquent on payments. Student loan payments, however, are continuously reported. Because your payment history is the most important factor in your credit score, paying at least the minimum payment on your student loans on time every month will help build your payment history and improve your score.
Mix of credit
Student loans can help diversify the type of credit reported on your credit history. Lenders want to see that you have experience managing and paying off different types of credit. Other types of credit they look for include mortgages, auto loans, and credit cards. The more variety, the more it helps your score.
Longer credit history
Student loans can also help build a long credit history, another important factor in determining your credit score. Many people with great financial habits have lower credit scores because they are young and only started using credit within the past couple of years. Student loans are often taken out at a fairly young age, so people who have them often end up with lengthier credit histories than their peers.
When student loans hurt your credit score
On the other hand, student loans can drag down your credit score. If you don't stay on top of payments or mismanage taking out new loans, the damage could take years to repair.
Late payments are one of the worst marks you can have on your credit report, and removing a late payment is not easy. Your student loan provider can report your account as delinquent beginning at 30 days late and can continue reporting it at 60, 90, 120, 150, and 180 days late—a recipe for a dramatic drop in your credit score if you continue to put off payment. If your account isn't resolved, it can then be sent to collections, further demolishing your credit score.
If you are unable to make your minimum payment, call your lender immediately and try to work out a revised payment plan. They may be willing to suspend payments or change your monthly due date to better meet your needs.
New accounts and recent inquiries
Taking out new student loans, or opening several new credit accounts, can temporarily decrease your credit score. While student loans aren’t revolving debt, each student loan application results in a hard inquiry on your credit report. One hard inquiry may result in a small temporary decrease but isn't worth worrying about. However, lots of inquiries in a short period of time can bring your score down more significantly.
Protecting your credit when you have student loans
The best way to protect your credit with student loans is to never miss a payment. If you recently graduated or are unemployed, don't assume that you don't have to begin repayment. If you can't make a payment, never ignore it. You always have options, and lenders are generally willing to work with you.
A common option is to change your repayment plan to extend the life of the loan but lower your monthly payments. Keep in mind that you'll likely pay more interest over time with this option, but it is worth considering if you’re unable to meet your current monthly payments.
If you're unable to make any student loan payments at all, you may qualify for forbearance or deferment, depending on your situation. Forbearance allows you to stop making payments for a set amount of time, but interest will continue to accrue. Deferment allows you to put your payments on hold, but the government will cover the cost of your interest payments. Exploring these options can help lower your monthly payments and protect your credit score.
You should never take on more debt to improve your credit score. However, if you already have student loan debt, it's important to know exactly how it affects your credit and how to use it to your advantage.