At this point we are all familiar with the problems that student loans are creating for recent graduates and even for those who graduated years ago. But one important topic that is often overlooked is the effect student loans have on credit scores. As it turns out, student loans and credit scores form a powerful combination. Together, they can make or break your financial future. If you don’t take important steps to manage the debt, your credit score could be seriously impacted. And, most importantly, this can have a lasting negative impact, making it more difficult to buy a car, get a mortgage, or reach other financial milestones. We are going to explain how student loans impact your credit score and teach you strategies to keep your credit in good shape while managing student loan debt.
How is a credit score determined?
The primary credit score, the FICO score is determined according to five factors. The chart below is a guide for how the FICO score is calculated for the general population. It varies by individual, depending on each unique financial situation.
Why do I need a good credit score?
A good credit score will earn you better terms when you borrow money, such as with a car loan or mortgage. It can even affect your ability to get a job. So, if you struggle with your student loans to the point that they hurt your credit score, you might be setting yourself up to receive bad loan terms. Take a look at how the terms for a $10,000 car loan vary by credit score:
|FICO® Score||APR||Monthly Payment|
How Delinquent Student Loan Payments Affect your Credit Score
Student loans begin to hurt your credit score when you miss a payment. When you fail to pay on time, you have essentially violated the promissory note, which is the legal document you signed with the lender.
Luckily, a delinquent status won’t hurt you right away. For federal loans, delinquent accounts are not reported to the credit bureaus until they have been outstanding for 90 days. So, if you miss a payment by a week but are then able to repay, you will avoid any damage to your credit score. Just keep in mind that this payment must be the at least the amount needed to bring your loan back to current status.
If your loan remains delinquent for 90 days, your lender can then report it to the credit bureaus. When this happens, your credit score will take its first hit. How this affects you will depend on the severity of your situation and the status of your credit score before the delinquency. A drop in credit score wil typically make it more difficult to do the following:
- Rent an apartment and sign up for utilities
- Get a job
- Get a contract cell phone
- Take out a new loan such as a car loan or mortgage
Even if you are able to do some of these things, chances are you will be given less favorable rates, making the borrowing more expensive. It’s important to be proactive if you miss a payment or think you might miss a future payment.
Student Loan Default Poses Serious Threat to Credit Scores
It gets even worse if your delinquency continues. If your delinquency lasts for 270 days on a loan that is paid monthly, it moves from delinquency to “default.” For FFEL loans paid less than monthly (for example: a loan with quarterly payments), default status occurs after 330 days. When you have defaulted on a loan, the consequences are far more serious. At this point, your credit score will take a hit and:
- Your loan becomes ineligible for deferment, forbearance, and other repayment programs
- Your wages can be garnished
- Your tax refunds can be withheld
- You may be ineligible for state and federal aid
- Your account is sent to a debt collection agency
- You immediately become responsible for the entire unpaid loan balance along with collection fees
As you can see, the consequences of defaulting on a student loan are serious, and the impact on a credit score is significant.
How to Protect Your Credit Score from Student Loans
There are several ways consumers can prevent student loans from hurting their credit scores. The key is to communicate with lenders and act early.
Rather than waiting for the student loan to reach delinquent status, consumers should reach out to the lender as soon as they realize they may miss a payment. Depending on the type of loan, the consumer may be able to avoid making payments due to unemployment, economic hardship, military service, and other types of deferment. Many of these programs last for three years, and during this time the interest and principal are frozen. Contacting your lender early could mean saving thousands of dollars and avoiding damage to your credit score.
Even if you don’t qualify for deferment, you might try forbearance. This program allows you to stop payments or reduce payments for up to a year. In this case, interest still grows, but at least you are not expected to pay in full. You can qualify for forbearance for a number of reasons, one of which is that the total you owe each month for student loans is 20% more than your total income.
There is also a program called “discretionary forbearance,” which means that the individual lender decides whether to extend the program to you. If you can make the case that you are experiencing a hardship and cannot make the payment, they may be able to make some sort of arrangement with you.
To ensure that you get some sort of help and avoid damage to your credit score, follow these steps as soon as you have difficulty:
- Contact your lender(s) to explain your situation
- See if your situations meets Federal deferment or forbearance eligibility guidelines
- If not, continue to contact your lender about a discretionary forbearance or hardship program
- Sign up for student loan counseling to help you explore all of your options and make the most of your monthly budget
Using Student Loans to Improve Credit and Build Credit History
So far, we have discussed the ways in which student loans can completely wreck your credit score. Hopefully, that won’t happen and you can use strategies and programs like deferment to help lighten your burden while you get back on your feet. For those who are able, following this guide on the best way to pay off student loans can be a great strategy to get out of debt and build up a solid credit score.
But in some cases you can actually take advantage of student loans and use them to improve your credit score. If you are budgeting wisely and making the monthly payments, you could see a big boost to your credit score over the course of your student loan repayment.
This is significant because we know that college-aged consumers are having a hard time building credit. Young consumers are having a harder time getting loans and credit cards and are even turning to more dangerous credit options with hidden fees and more dangerous terms.
But you can avoid this altogether and build a solid credit history just by making your student loan payments each month. If over the course of an average repayment (10 years) you can keep your accounts current, you will be in good shape. Even getting ahead of your payments is a good idea, if you are able. Some people are concerned about damaging their credit score by closing an account too soon, but this shouldn’t be a problem with your student loans. In fact, if you are able to pay off your student loans early, this will likely mean that you made consistent on-time payments and will thus have a much higher credit score than when you started repaying the loans.
Student loans and credit scores create a powerful combination. It’s up to you to determine how that power will be used. If you neglect your loans and don’t communicate with your lenders, student loans will hurt your credit score. The damage to your credit score might be so significant that you can’t get other loans, and that would be a tough financial position for anyone.
On the other hand, if you budget effectively and let the lenders know when you need some extra help you can create a promising financial situation for yourself. You can use the first few years after college to build a solid credit history, making financial milestones more achievable for you later in life.