Does Paying Off Student Loans Build Credit?

Loans, Managing Your Student Loan Debt, Student Loans

Things change when you leave school. Suddenly there are more bills to pay, including your monthly student loan payment. Meanwhile, if you want to take out a loan to buy a car, rent an apartment or get a mortgage to buy a home, you’ll need to know what your credit score is and how to improve it. 

Not sure how your student loan payments can affect your credit score? Read on to find out more.

How Does Paying Student Loans Build Your Credit?

Your credit score is a three-digit number that ranges from 300 – 850. These numbers are calculated by credit bureaus based on the information contained in your credit report, which is a record of all your past and current debts. The higher your credit score, the cheaper it is to borrow money.

But building and improving your credit score doesn’t happen overnight. When credit bureaus, like Equifax®, Transunion® and Experian™, determine your credit score, they do it using a variety of factors, including:

  • Payment history: Do you make all your payments on time? If not, have you ever gone into collections or bankruptcy?
  • Credit utilization: If you’re carrying a balance on your credit cards, how much do you owe compared to the available credit you can borrow against?
  • Length of credit history: How long have you had loans or credit accounts?
  • Credit mix: Do you only have credit cards? Or do you also have other types of loans, like car loans, mortgages and student loans?

A student loan can help you build credit because:

It’s a long-term installment loan

You’ve taken out private and/or federal loans for school, and now you’re paying them back in monthly installments over a fixed period (usually 5 – 20 years). By making consistent payments, you’re demonstrating that you can manage long-term debt. Successfully managing long-term debt can help improve your credit score as long as you make your payments on time and in full.

It adds to your credit mix

Credit bureaus like to see that you can handle different types of debt. If most of your current debt comes in the form of credit cards and other forms of revolving credit, having a student loan can improve your credit mix. 

Showing you can handle a fixed-rate loan, such as a student loan, helps demonstrate your creditworthiness to lenders when seeking other types of loans, such as an auto loan or mortgage.

Reinvest Your Student Loan Payment

Take the money you used to pay your loans each month and use it to pay down high-interest debts, create an emergency fund or invest it in a Roth IRA.

Can Student Loans Hurt Your Credit?

While student loans can be a great way to pay for your education, they do come with potential drawbacks for your long-term financial health. Having a large monthly payment when you’re just starting out can be a burden that delays traditional life milestones. 

Also, the money you spend on student loan payments may also cause you to rely on credit cards or other forms of high-interest debt to make ends meet.

Think about this, prior to the COVID-19 pandemic the average monthly payment for U.S. student loan debt is $200 – $299.[1] So let’s say your monthly payment is right in the middle at $250 a month. That’s $3,000 per year you can’t use to:

  • Save for a down payment on a home
  • Build financial security before you start a family
  • Buy a car
  • Invest in more education to enhance your career prospects
  • Create an emergency fund
  • Invest for your retirement

In addition to the money you need to pay each month, your student loans can also affect your credit in other ways.

Missing a single payment

Being able to make your payments on time every month can help build your credit, but what if you miss a payment?

Something to keep in mind is that while you may only make one student loan payment, you could be paying multiple loans. 

For example, when you take out federal student loans, you have to reapply for a new loan each school year. If you went to a 4-year college or university and took out loans every year, you could be paying for 4 or more loans. Your student loan servicer collects your monthly payment and distributes it to cover each of your loans.

Because your payment covers multiple loans, missing a single payment could lead to multiple late payments appearing on your credit report at the same time, which can damage your credit score. Getting back on track with your payments will help, but it will take some time for your score to return to where it was before.

Delinquent payments or default

While missing a single payment is bad, being delinquent is even worse.

​​If you miss multiple payments in a row, you risk going into default. When that happens your credit score will definitely take a hit. You also risk having to pay extra fees or having money taken directly from your paycheck or tax return to cover your balance.

For federal student loans, you have 270 days before you go into default, but usually less time for private student loans.[2]

The good news is that lenders don’t want you to default on your student loans. If you’re having trouble making your payments, talk to your lender. For federal student loans, they may be able to help you with loan deferment, forbearance or an income-driven repayment plan. 

Private lenders offer fewer options, but they may be willing to renegotiate the terms of your loan to make your monthly payments more affordable.

Debt-to-income ratio

In recent years, as student loan debt has ballooned, the amount an individual borrower needs to repay has also increased. This comes at a time when incomes have been relatively flat. This has impacted student loan borrowers because it negatively affects their debt-to-income (DTI) ratio.

Your DTI ratio is calculated by adding up your fixed monthly expenses, including:

  • Rent or mortgage payments
  • Credit card minimums 
  • Auto loan payments
  • Personal loan payments
  • Student loan payments 

To calculate your DTI, your total gets divided by your gross monthly income (think: the money you make before taxes). 

This number is important, especially if you want to take out a mortgage. Lenders prefer that your DTI is less than 36%, and you can’t qualify for most conventional mortgages if your DTI is higher than 50%.

Let’s say you’ve got a college degree, you’re between 25 and 43 years old and you make $55,000 a year, which is the average salary for adults with an undergraduate education.[3]

Divide that into monthly income and you’re earning $4,583 before taxes. If you’re making the average student loan payment of $250 per month that we mentioned earlier,[1] that’s approximately 6% of your pretax income going toward your student loan payment. 

Let’s assume your other fixed monthly expenses like rent or mortgage, credit card payments and other debts equal $2,100 a month. That puts your DTI at 44%. Add a $250 student loan payment to that total and your DTI is now 51%, which means you probably won’t qualify for a mortgage.

Keep in mind that DTI doesn’t factor in expenses like food, clothing, entertainment, health care and other costs of living. DTI also doesn’t account for federal, state and local taxes and Social Security contributions, which can easily lower your monthly income by an additional 15% – 25%.

Automate Your Payments

It’s easy to forget student loan payments when you’re staying on top of other bills. Automating payments through your loan servicer or bank can help you avoid late payments.

Can Refinancing Student Loans Help Your Credit Score?

Federal student loans tend to offer very competitive interest rates, currently ranging from 3.73% – 6.28%.[4] However, if you’ve increased your income and improved your credit score, you may qualify for a lower interest rate with a private student loan refinance. 

Just keep in mind, that once you refinance your federal student loans into a private student loan, you’re no longer eligible for federal student loan relief programs, like income-driven repayment plans or, as we’ve witnessed, payment moratoriums during a pandemic. 

In March 2022, the Department of Education deferred federal student loans to help borrowers affected by the COVID-19 pandemic.[5] If you refinanced your federal loans before the pause, you missed out on the payment suspension and 0% interest on your loans. 

Are There Other Ways To Build Credit as a Student?

If you’re starting out and looking for other ways to improve your credit, there are other options available.

Become an authorized user

If you have a family member with excellent credit, see if they’d be willing to add you as an authorized user on their credit card. You’d get a copy of their card in your name to use like any other credit card. 

And the bonus? The credit card shows up on your credit report and can help improve your credit score. Just make sure you use the card responsibly, and both you and the cardholder have an understanding of how and when you can use the card.

Open a student credit card

Credit card companies are always on the lookout for future customers. Many companies will offer credit cards to students, even if they don’t have a credit history. Just keep in mind that these cards often come with low credit limits and higher interest rates compared to other credit cards. So use the card sparingly and make sure to pay off your balance every month.

Get a secured credit card

A secured credit card works like a regular credit card, except instead of borrowing against a preset credit limit, you provide the lender with the money you’ll be borrowing against. Essentially, you’re borrowing from yourself – and it can help improve your credit.

Credit builder loan

Credit builder loans are like a loan in reverse. You agree to borrow a certain amount of money and start making monthly payments for a set period of time. At the end of the loan term, you get the money.

You could do the same thing by saving the money yourself. But the benefit of a credit builder loan is that the loan shows up on your credit report. This shows lenders that you can be trusted with a loan and may make them more willing to offer you a credit card or loan.

You Can Build Your Knowledge While Building Your Credit Score

There is no denying that, for many borrowers, student loans feel like an unshakable burden. But the silver lining in the dark cloud is that they can also serve a valuable purpose. Paying off your loans consistently can help improve your credit score and make borrowing easier in the future.

Source link

Products You May Like

Leave a Reply

Your email address will not be published. Required fields are marked *