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Student loans are some of the first debt young adults take on. Like all types of debt, the way you handle it could help or hurt your chances of securing credit in the future.
Want to keep your credit score high while you're paying back your student loans? You need to understand how lenders calculate your score and how student debt affects it.
The five factors that make up your credit score
There are several credit scoring models in use today; the two most popular are FICO® and VantageScore. Both use a scale ranging from 300 to 850. A higher score indicates a greater degree of financial responsibility.
Each system looks at the same factors but weighs them differently. The five biggest factors are:
- Payment history
- Credit utilization ratio
- Length of credit history
- Credit mix
- Number of hard inquiries
Here's a closer look at how your student loans can impact all of these factors.
1. Payment history
Your payment history is the single biggest factor that determines your credit score. It accounts for 35% of your FICO® Score, which is the one most commonly used by lenders. Payment history is a key measure of financial responsibility, and failing to pay back your debt on time could indicate that you're living beyond your means. And that means you’re at risk of default.
The effect of a late payment depends on how late the payment was and your current credit score. Creditors usually don't report late payments until they're 30 days late, and payments that are 60 or 90 days late will damage your score more than a 30-day-late payment.
It may seem counterintuitive, but the higher your credit score is, the more a late payment will hurt it. FICO® says a single 30-day late payment could drop a 780 score by over 100 points. When your score is lower to begin with, there isn't as far to fall. So a late payment may not hurt your credit score as much.
If you miss enough payments that your student loan goes into default, this will appear on your credit report, too. And it'll stay there for seven years. This devastates your ability to take out new loans and lines of credit. Fortunately, if you have a federal student loan, you may be able to rehabilitate it and remove the default from your credit history.
A good payment history helps boost your credit score. If you make at least the minimum payment by the due date every month, your credit score will begin to rise. This is a great way to establish yourself as a responsible payer and make it easier to get new loans and lines of credit.
2. Credit utilization ratio
Your credit utilization ratio is the percentage of your total available credit that you're using. This mostly applies to revolving debt like credit cards, where you can borrow up to a certain amount each month.
If you have a $10,000 credit limit and you use $2,000 per month, your credit utilization ratio is 20%. But student loan debt is considered installment debt because of its regular monthly payments. Installment debt has a smaller impact on your credit utilization ratio.
It still impacts your score to some degree, especially early on when the bulk of your student loan debt is still outstanding. But carrying $20,000 in student loan debt won't hurt you nearly as much as $20,000 in credit card debt.
As long as you keep your revolving credit utilization low and you haven't taken out a bunch of other loans at the same time, you shouldn't have to worry about your student loans’ impact on your credit utilization ratio.
3. Length of credit history
Your credit report records how long you've been using credit and how long your credit accounts have been open. Lenders like to see a long credit history because it gives them a better sense of how well you manage your money.
Taking out student loans can help you get an early start on building your credit history. The standard federal student loan repayment term is 10 years, so the loan stays on your credit score for a long time. This helps raise your average account age.
But that doesn't mean you shouldn't pay off your student loans early if you can. The small boost it may give to your credit score probably isn't worth all the extra you'll pay in interest if you're only making the minimum payment.
4. Credit mix
As I mentioned above, credit is broken down into two types: revolving debt and installment debt.
The most common form of revolving debt is credit cards. They enable you to borrow up to a certain amount, but the actual amount that you borrow may vary from one month to the next. Installment debt, on the other hand, has predictable monthly payments for a set period of time. Student loans fall under this category, as do mortgages, auto loans, and personal loans.
Having revolving and installment debt gives your credit score a slight boost by showing you can be responsible with different kinds of debt. Many college students have credit cards, and student loans can add installment debt to the mix.
Having a good credit mix only has a small impact on your credit score. But it's an easy way to earn a few extra points.
5. Number of hard inquiries
When you apply for a student loan or any type of credit, the lender does a hard inquiry on your credit report. This is where they pull your credit reports to assess your financial responsibility. Unlike a soft credit inquiry, which won't affect your credit score, a hard credit inquiry will drop your score by a few points.
Lenders understand that borrowers shop around and compare rates when taking out a loan or line of credit, so most credit scoring models consider all inquiries within a 30- to 45-day period as a single inquiry. Keep this in mind when shopping for student loans and try to submit all of your applications within a month of each other so you don't end up with multiple inquiries on your report.
Bonus: debt-to-income ratio
Your debt-to-income ratio isn't a part of your credit score, but lenders look at it when assessing how likely you are to make your payments. It's a measure of your monthly debt payments compared to your monthly earnings.
Each lender will have its own opinion on what constitutes an acceptable debt-to-income ratio. But you generally don't want yours to exceed 30%. The lower you can keep it, the better.
You may not have much control over your student loan payments or your income -- especially when you're fresh out of college. But you can reduce your debt-to-income ratio by diligently making payments, paying extra when you can, and pursuing promotions to raise your income. Be careful not to take on too much other debt, like credit card debt, in the meantime.
Student loans have tremendous power to improve or ruin your credit, but by understanding the ways they affect your credit score, you can take steps to make sure your student loan debt reflects well on you.