Most people that graduate college come out owing both student loan and credit card debts. Research published last year by Fidelity Investments – Cost-Conscious College Graduates Study – showed that the majority of grads (roughly 70%) end up with debt that exceeds $35,000, on average. Half of those surveyed were surprised by the extent of their debt and had no idea they were in that deep. In addition to the debt itself, there are the implications to how it will impact your credit score. Today we take a look at how a credit report works and how your student debt can impact that all-important number.
How credit scores are calculated
There are three major credit reporting agencies – Equifax, Transunion and Experian – and all use the same basic scoring model called FICO. The Fair Isaac Corporation (FICO) method calculates credit scores ranging from 300 to 850. The higher the better. There are five aspects of your financial history that make up your credit score:
Payment history – This is how promptly you pay your bills, how often you’ve paid them late, whether any of your accounts have been reported for collections and if you’ve filed for bankruptcy. Roughly 35% of your score depends on this criteria.
Outstanding debt – This considers how much you owe on installment loans (car notes, mortgage, etc.) and what percentage of your revolving credit you are utilizing. (i.e. if you have a $1,000 credit card limit and are using just $200, this is much better than it being maxed out). This criteria makes up about 30% of your FICO score.
Length of credit history – This is the depth of your credit history. If you’re just starting out, or all your accounts are new, this will be less favorable. If you have a long-standing credit card account you’ve always paid promptly and keep the balance low, that’s a boon to this part of your score. About 15% of your FICO score is weighted on this aspect.
Inquiries on new credit – Interestingly, getting a new account can actually lower your score until the account “matures.” Shopping for credit can also be damaging. These are called inquiries and having a lot of them can lower your score. Roughly 10% of your score hinges on this.
Types of credit – Variety in your credit profile is beneficial. A blend of revolving credit and installment loans produces the best result. Having only credit cards or only installment loans can lower your score even if your accounts are all kept current. This makes up the last 10% of the FICO calculation.
How not paying student loans impacts your credit rating
If you can’t pay your student loans and fall behind, your credit will take a hit. If you continue to struggle, your score will decline with every missed, delayed or partial payment. If you lose your job, have an accident or other life event that makes you unable to work and you know you’re not going to be able to make your payments, applying for forbearance or deferment will give you breathing room. While this will be noted on your credit report, your score will not suffer. If your loans go into default or delinquency, your credit rating will take an even bigger hit. This should be avoided at all costs. In addition to forbearance or default, applying for Income Based Repayment can help you get your loans under control and salvage your credit score.
How paying your student loans off early impacts your credit rating
I’ve read warnings that you shouldn’t pay your student loans off early because your credit will suffer. This is mediocre financial advice. Yes, if you pay off your loan balances, your score will take a dip because it will impact the blend of your debt and will remove an older account with positive history, but getting shed of school debt more than makes up for this. Plus, without your student loans in play, you can afford other beneficial installment credit to beef your score back up, such as a car loan or a mortgage – something many graduates can’t afford to buy when they’re saddled with student loans.
A reminder of why your credit score matters
If you’re of the school of thought that your credit score is just a number, think again. Of course it doesn’t measure your worth as a person and isn’t a yardstick on your humanity, but what it does do is determine how much you will pay for many, many things in life. Even things you pay cash for consider your credit score in what they charge. Car insurance, homeowner’s insurance and lease agreements all rely on a credit score and you can pay more, be turned away or be required to pay a heftier deposit if they don’t like what they see on your credit report. For an auto loan, mortgage or credit cards, your interest rates will be lower the higher your credit score is, and that can save you big bucks.
To stay informed on your student loans, sign up for Tuition.io’s free student loan tool to track your debt, keep an eye on monthly payments and make sure your payments are properly posted. Read our blog for lots of tips on dealing with your debt and, if you’re struggling, check out our Student Loan Help Center for info and how-to guides on deferment, forbearance and income based repayment.