Student Loan Smarts: How Student Loans Affect Your Credit Score

12.17.13 Credit Score

Story provided by SoFi

Are you currently paying down a substantial student loan balance?  If so, you’re not alone.  A recent study shows that more college seniors are graduating with more student loan debt than ever before, and the burden is typically even higher for those who’ve completed graduate, MBA, law or medical school programs.

While an investment in higher education can pay off in a big way, you can never underestimate how important it is to treat that debt responsibly.  From the day you apply for a loan to the day you pay it off, your actions can have an impact – either positive or negative – on your credit score and, by extension, your financial future.

As a student lender, we get a lot of great questions about how student loans affect our borrowers’ credit scores.  Here’s how we answer some of the big ones:

Question #1: How is my credit score calculated?
Historically, most lenders have used FICO scores to determine whether to extend credit and at what interest rate.  Since FICO is used throughout the lending industry (including mortgage, auto and credit card), it allows for an apples-to-apples comparison of potential borrowers.

Unfortunately, how FICO calculates your credit score is a bit of a black box.  While the variousfactors and weightings used are publicly available on FICO’s website, the algorithms are proprietary.  Which means that nobody can predict exactly how much a specific event will affect your score.  For example, a late payment will likely reduce your score, but by how many points is anyone’s guess.

That said, there are a few things that are generally known to be good or bad for your credit.  Paying bills on time, keeping credit card balances low and reducing the amount of debt you owe are three key ways to maintain a good score.

Question #2: Will shopping around for a better interest rate hurt my score?
One factor that can be a red flag for FICO is the number of inquiries they receive from lenders wanting to see your credit report.  In other words, if it looks like you’re shopping around for credit, it could negatively impact your score.  Since undergrad borrowers can typically cover the majority of their costs with federal loans (most of which don’t require a credit check), this is usually a question we hear from grad school borrowers and those refinancing existing loans who, understandably, need to shop around for the best interest rate on a private loan.

The good news is that FICO attempts to distinguish between a search for a single loan and a search for many new credit lines, so as long as you do your rate shopping during a concentrated period of time, you should be okay.  If you really want to avoid inquiry overload, do your homework before applying for a loan.  Private lenders should state the range of rates they offer on their websites, as well as general eligibility criteria (so you have a good idea whether you’ll qualify before you apply).  And ask if they can tell you the interest rate you would receive without doing a “hard” credit pull, which may affect your score.  For example, if you qualify for pre-approval with SoFi, you can see the interest rate you’d get before a formal credit check is logged.  You can’t get a loan without an eventual inquiry, but this service allows borrowers to shop around first.

Question #3: How bad is it to make a late payment?
Paying on time is obviously important, but what some borrowers don’t realize is how damaging it is to not pay on time.  Even if your credit history is pristine, it only takes one report of being 30 days past due to cause a material change in your score.  Whether you were short on cash or just simply forgot, the algorithm doesn’t distinguish and the result is the same.

The bottom line?  Don’t pay late.  If you have trouble remembering to make your payments, set up an automatic payment plan – some lenders will even give you a discounted interest rate for doing so (SoFi’s AutoPay gives borrowers a .25% reduction in rate).

And if you can’t make a payment for financial hardship reasons, the best thing you can do is talk to your lender right away.  Most federal loans and some private loans offer protections such asdeferment and forbearance, which can give you temporary relief and often minimize the impact to your credit.  But there’s absolutely nothing your lender can do to help if you won’t return their calls.

Question #4: How does consolidation or refinancing affect my credit?
The actual process of consolidating your student loans shouldn’t impact your credit score, since you’re simply replacing multiple loans with one loan, and the amount and type of debt remains the same.  However, if you’re able to refinance your loans at a lower interest rate, the benefits of doing so can have an indirect impact on your credit.  For example, refinancing may allow you to pay down the loan faster, and having a lower balance is generally a positive thing in FICO’s eyes.

And if you refinance your federal loans with a private lender, rest assured that credit bureaus don’t view the two types of loans any differently.

Question #5: Should I avoid paying off my loans too quickly?
One common misconception is that student loans are considered “good debt”, and as such it can actually damage your credit if you pay them off too quickly.  The truth is that student loans are considered installment debt and, in FICO’s eyes, aren’t viewed differently than any other installment debt, such as mortgage or auto loans.  However, installment debt is different from revolving debt (like credit cards), and it’s generally better to have positive track records with both of these types of loansversus just one or the other.

Paying and closing any account satisfactorily is generally a positive thing for your credit.  However, FICO likes to see how you manage your credit, so as long as the account is open and in good standing, that could help your score, too.  But the impact is likely small, and you should consider the potential trade-offs.  For example, you may be paying additional interest by leaving the account open.  Also, a high loan balance may make it harder to qualify for new loans – something to think about when it comes time to buy a home.

Credit is a powerful tool that can allow you to do a lot of positive things in your life, but if you’re not careful it can also hold you back.  For many borrowers, student loans are their first experience with carrying a large debt load, which means mistakes may be inevitable.  The most important thing you can do is educate yourself about how to take good care of your score – and eventually, it will take care of you, too.

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