A lot has been written about the $1.7 trillion of student loan debt outstanding. But not much has been written about the relationship between student loans and credit scores. Student loans can increase or decrease your credit score – you should know how this works.
Why are there credit scores?
It’s not news that technology has replaced human interaction as the basis for getting a loan. Few remember going to a credit union or bank, meeting a loan officer who collected information and then made a decision whether to lend money or not. As data and technology have developed, financial institutions are increasingly relying on faster processing, quantitative risk models and less personal interaction to make lending decisions.
Today, we apply online and, in many cases, get an instant decision based largely on a consumer’s credit score as calculated by one of the three national credit bureaus: Equifax, Experian and TransUnion. Each of these companies collects information about consumers and does a calculation that produces a number between 300 to 850, commonly referred to as a FICO score. Get your free credit score with the Federal Trade Commission.
It’s important to know that your credit score affects your ability to get a loan and it also helps determine the interest rate you will pay. Those with higher scores are judged to be more “credit worthy” (i.e. more likely to repay) and will be offered lower interest rates. Subsequently, those with lower credit scores will likely have a higher interest rate.
Credit scores are used to help consumers borrow money and then are influenced (i.e. they move up and down) based on a number of factors including how well a borrower pays off the debt.
What goes into a credit score determined?
There are several different credit scoring systems. The FICO® scoring system is one of the best-known scoring systems. It uses a scoring system from 300 to 850 and assigns a credit score based on the following:
These factors do affect a FICO score:
|Missed Payments||Missed payments have a negative impact on credit scores, build credit by paying your bills on time|
|Revolving Utilization||The ratio of money used in a period to the amount of money available on the credit line|
|Length of Credit||How long you’ve been building credit|
|Total Accounts||The variety of credit accounts open|
|Inquiries||The number of times your credit score is reviewed or looked at by a third party|
These factors do not affect a FICO score:
- Age, sex, marital status, race, color, religion
- Salary or Income
- Length or place of residence or employment
- Debt ratio: total debt divided by total assets
Are credit scores necessary to get a student loan?
Most student loans are made without first checking for a credit score. Federal Direct Student Loans, which account for approximately ninety percent of all student loans, are offered to students without any credit test or reliance on a credit score. This is good news for students who are just starting out and would not qualify to borrow for college based on their own credit score if they even have one.
The remaining loans (a.k.a. private loans) are made by credit unions, banks, credit card companies, states and others who rely on credit scores to make a decision to lend and assign an interest rate to the loan. Student Loan Basics: Choosing Federal and Private Student Loans highlights this and other differences between federal and private loans.
For most private student loans, the lender will check the borrower’s credit and almost always require the student to enlist the help of a parent or someone else (a.k.a. a co-signer) with a good credit score. In essence, the student is piggy backing on the good credit history of the co-signer of the loan and can start establishing their own credit history and hopefully a good score by paying on time.
How does a student loan affect my credit score?
Student loans that have entered their repayment period will help borrowers who pay on time establish good credit. Borrowers who are delinquent in making payment will see their credit scores decline.
As shown above, there are a number of factors that result in a credit score. Student loans offer young consumers an opportunity to establish good credit.
Although a credit score is not necessary to get most student loans, they can be important. Families borrowing from a private lender will need a good credit score to be eligible for a loan and get a good interest rate. When student loans enter repayment, a borrower’s credit score will be affected so paying on time is important.
It’s vital to understand the basics of student loans before you select one. As we like to say: know before you owe.