If you have opted to finance your higher education, you may be wondering does a student loan affect your credit score. The cost of a college and university education has grown so tremendously that, for most people, a student loan is the only way to make it feasible. But what you may not realize is taking out a student loan can be a good thing for your credit. You should know what to expect. We will show you how borrowing for your education will affect your financial future and your credit score.
Understanding Your Credit
First things first – if you want to understand how does a student loan affects your credit score, then you’ll need to understand credit! For many who are just starting out, you have not established your credit and you may not know much about it.
Simply put, your credit is a way of saying if you are trustworthy to be loaned money. All your life, you’ll have different experiences and numerous financial transactions. Whether it be through credit cards or buying a car or taking out a loan, your payments will show your credibility. The actions you take will shape your financial status and your credit.
Your credit report is a collection of all your financial information such as bank accounts, credit card payments, car loan information, mortgages and student loans. All the financial transactions you take are reported by your lenders and captured by various credit bureaus and agencies. Your financial data is then compiled into your credit report. Your credit report is constantly changing and you have various versions of it, depending on which credit bureau and at what point in time/
Last, your credit score is the 3-digit number (ranging from 350-800) that represents your overall creditworthiness. Like a credit report, your credit score has various versions depending on which credit reporting agency. Your score also is constantly changing as well.
Credit scores are calculated by the credit score agencies using certain factors from your credit report and usually weighted as follows:
- Payment history 35%
- Amount Owed 30%
- Length of Credit History 15%
- New Credit 10%
- Credit Mix 10%
TIP: Make sure you check your credit report regularly to make necessary corrections and to optimize your credit score.
What is a Student Loan?
A student loan is a type of installment loan used specifically to pay for educational purposes. It is different than other types of loans. A student loan is a lump sum of money that is loaned to you for school. Then, you pay back that sum of owed money over time with fixed regular payments and an agreed-upon interest rate.
There are different types of student loans and these offer varying terms, repayment options, and interest rates:
- Federal student loans – offered by the government
- Private student loans – offered by a private-sector lender (bank, credit union)
Federal loans are run by the U.S. Department of Education and include Direct subsidized loans, Direct unsubsidized loans, Direct PLUS loans, and Direct consolidation loans. They usually offer low-interest rates and flexible repayment plans. To apply for this type of student loan, you’ll submit a FAFSA (Free Application for Federal Student Aid). You’ll include income and investment information which along with the college costs will determine your eligibility for a package that includes one or more government loans and perhaps some grants (money that is not paid back) and work-study opportunities.
Private loans are provided by various sources, including banks, credit unions, or other financial institutions. As a student, you may apply anytime for a private loan and use it for anything including tuition, room and board, books, living expenses and more. These loans are not based on financial need but rather on your creditworthiness. These lenders will look at your credit score.
How Does a Student Loan Affect Your Credit Score?
As you make payments to your loan, this information is reported most likely from your lender to the three major credit agencies – Equifax, Experian, and Transunion. If you pay on time every time, you will establish a sound financial record. Your credit score which is based on your credit report information will be excellent. But only if you pay on time!
When Is Your Information Reported?
A federal student loan won’t show up on your credit report until you actually take out the loan. Adversely, a private student loan can show up during the application process, as a hard inquiry. Lenders can opt to do a soft inquiry that does not end up on your report or affecting your credit score. This is useful if you are just shopping around. Once you are ready to formally apply for the loan, the lender can do the hard inquiry and this should only impact your score slightly.
It is worthwhile to know that while your federal student loan is in deferment status (you are not actively making payments), it can be listed on your credit report.
How Your Student Loan Will Help Your Credit
If you review the factors that affect your credit score, you can understand how your student loan comes into play. Specifically, your student loan can help your credit score by affecting the following:
- It is a new loan.
- It changes the mix or the diversity of credit types you have.
- It affects your payment history.
Importantly, your student loan may establish your credit. Since a lot of students are young and starting out, their student loan is one of the first lines of credit. Having student loans provides you a way to help you qualify for other credit types, like revolving credit like a credit card.
A key point here is that payment history is the most important aspect of your credit scores. It typically makes up 35% of your scores. Late payments on any debt hurt credit scores, which remains true of student loans. It is especially important to make your monthly payments on time so that you have the best credit score you can.
What It Does Not Affect
Because a student loan is an installment loan you pay regularly each month, it has very little effect on the portion of your score that calculates debt usage—the amount of the credit limits you’re currently using.
Your credit utilization ratio is the percentage of your total available credit that you’re using. This applies to revolving debt like credit cards, where you can borrow up to a certain credit limit. The takeaway here is that $25,000 in student loan debt is much better for your score than if you have the same amount, $25, 000, in credit card debt. Try to keep your credit utilization low by way of not accumulating credit card debt and your score will thank you.
How Can They Hurt You
If you find yourself unable to pay your student loan, this can impact your credit. With a federal loan, your missed payment won’t be reported to the three major credit bureaus until you’re 90 days delinquent. This is helpful if you simply forgot to pay or it’s a small interruption you can quickly recover from. Keep in mind though that if you have a private student loan, your lender may report a missed payment anytime. Each private lender has different protocols but as soon as your account is in default, a late payment is reported, and your credit score can suffer.
Know that a student loan default could remain on your credit report for seven years. This can take many years to recover your good credit health. The government or private collection agencies can take additional measures to collect payment such as garnish your pay.
If you’re in trouble and cannot make payments, it’s very important you talk to your loan provider. There may be options for student loan repayment assistance such as income-driven repayment, deferment, or forbearance.
Now that you know how student loans affect your credit score, you can make sure you only do things that will help. This includes borrowing only what you need through a student loan, paying on time every time, and if you find that you are having trouble with payments, to communicate with your lender. Student loans can be a great way to establish and build your credit score and get the education you want.