College students and graduates can use student loans to build a great credit score. These three steps will help you understand the credit scoring process and how student loans can help young consumers build a high credit score and open opportunities for future borrowing.
Step 1: Understand the players and how credit scores are calculated
Equifax, Experian, and TransUnion are credit reporting agencies. They provide consumers with an opportunity to understand the credit scoring process and view their unique score. They also work with companies that have credit scoring models to supply information about how we handle our credit: do we pay on time? Who has given us credit? How much? Do we pay our entire balance each month or do we carry outstanding balances?
Although several companies use this data to produce a credit score, Fair Isaac Corporation’s FICO® score is the best known and the one most often used by banks, credit unions, credit card companies, and others who make decisions regarding student and other consumer loans. The FICO® Score is calculated using data received from the credit reporting agencies and applied as follows:
- 35%: Payment history
- On-time payments help build stronger credit.
- 30%: Debt burden (amounts owed)
- Charging less each month than the monthly maximum on the card or line of credit helps build stronger credit.
- 15%: Length of credit history (“time on file”)
- Credit scores increase if a borrower has open and active accounts for longer periods with the same lender.
- 10%: Credit mix
- Credit scores increase when borrowers have a variety of types of credit: installment loans, credit cards, retail accounts and mortgages.
- 10%: New credit searches
- Credit scores decrease when a borrower attempts to open several new credit relationships in a short period of time.
Based on the information collected, a FICO® score between 300 and 850 is generated. Higher scores indicate that a borrower has previously managed their credit well and is more likely to repay the loan or credit card. These customers represent a lower risk of loan default or delinquency to lenders and therefore often receive more favorable terms, i.e., lower interest rates to borrow money.
Learn how to get your free credit score here.
Step 2: Know if a credit score is required to get the type of student loan you want.
There are two sources of student loans:
- The U.S. Department of Education
- Other lenders including banks, credit unions, credit card companies, states, colleges and universities
The U.S. Department of Education is the lender for the Federal Direct Student Loan program, which accounts for approximately 80% of all student loans. Federal Direct 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 – assuming they had one.
The U.S. Department of Education’s PLUS (Parent Loan for Undergraduate Students) Loan program also does not require a score, however, it does require that parents not have “adverse credit.” As the name implies, PLUS loans are made to parents. Therefore, any credit score increases or decreases resulting from the loan would impact the parent’s credit score. Students are not named on this type of loan and have no legal obligation to make payments.
The remaining loans (a.k.a. private loans) are made by credit unions, banks, credit card companies, states and others who use credit scores to help decide whether to extend credit to the student. Realistically, high school students will not have a credit score acceptable to most lenders. Most high school students and recent graduates would not have prior borrowing experience or income to prove to a lender that they could repay the loan.
To assist students and establish a lending relationship with that student, most private student loan lenders offer students an opportunity to apply for the loan with someone who would pass the lender’s credit test, often a parent or close relative. The lender uses the “co-signer’s” credit score, income, and other factors to make the loan. When a co-signer steps up to help the student, both the student and the co-signer are considered to be the borrower. If the student misses a payment, the lender will contact the co-signer for payment.
Most private lenders also offer a “co-signer release,” which allows the co-signer to be removed from the loan once the student can pass the lender’s credit test on their own, or after a stipulated number of successful on-time payments. In essence, the student is piggybacking on the good credit history of the co-signer to begin establishing their own credit history and hopefully a good score by paying on time.
Step 3: Use student loans to build a strong credit score
Students borrowing from the Federal Direct Loan Program or a private lender as a co-signer have an opportunity to obtain credit early in life.
As consumers of education, they are likely for the first time making a large, expensive purchase decision that involves borrowing to buy the goods or services they desire. The key is ensuring that the amount borrowed can be comfortably repaid over time.
Remember that 15% of the FICO® score considers “time on file” – how long the borrower has been borrowing. A student loan affords many people who are less than 20 years of age an opportunity to begin building their time on file very early in their adult lives.
Students who opt to pay any interest due on the loan while they are still in school helps establish a history of making on-time payments – the most significant (35%) component of the FICO® score. To move their loved one in the right direction, some parents may provide the funds to their student in order to make interest payments while in school. The credit for making that on-time payment goes to the student borrower thereby helping to create a strong score.
Once a student loan is made, students can use it to build good credit by paying on time. Utilizing monthly automatic withdrawals is one way to help all consumers, including students, ensure that those payments are received on schedule. But it is critical BEFORE signing for the loan to determine whether you can make the projected payments as scheduled in the loan details. Just as with any other extension of credit – credit card, retail account, installment or mortgage – a lapse in payment or the failure to pay at all on a student loan will result in a lower credit score.
You can use this free Loan Repayment Calculator to estimate the amount you will have to pay based on the amount you borrow, the interest rate, and the number of months you have to repay the loan. For students, this can be a tricky endeavor because they likely will not know in advance how much they will be earning after graduating. A general rule of thumb to work off is for students to borrow less in total for college than they think they can earn in their first year after graduation.
Conclusion
Students and their families who understand how credit scores are calculated can better use the student’s loans to lay the foundation for an early start to a great credit score, thus establishing themselves as good credit risks early in their adult lives and affording them an opportunity to borrow at lower interest rates and with more favorable terms when it comes to equally significant purchases later in life such as cars and homes.