Introduction
Student loans are a necessary evil for many college students. With the rising cost of tuition, textbooks, and living expenses, it’s nearly impossible to avoid taking out loans to cover the costs of education. According to a recent study by Experian, the average student loan debt for graduating students in 2019 was over $35,000. While these loans are crucial for helping students achieve their academic goals, they can also have a significant impact on their credit scores and financial future.
Let’s explore the impact of student loans on credit scores and how students can navigate this aspect of financial planning.
Understanding Credit Scores
First, it’s essential to understand what a credit score is and how it is calculated. A credit score is a three-digit number that represents an individual’s creditworthiness. Lenders use credit scores to determine whether or not to approve a loan or credit card application and what interest rate to offer. The higher the credit score, the lower the interest rate, and the better the chances of securing a loan.
The most commonly used credit scoring model is the FICO score, developed by Fair Isaac Corporation. This score ranges from 300 to 850, with 850 being the highest and most desirable. It is calculated based on five main factors: payment history, credit utilization, length of credit history, credit mix, and new credit.
Now that we understand what a credit score is let’s dive into how student loans can affect it.
The Impact of Student Loans on Credit Scores
1. Credit Utilization
Credit utilization, or the percentage of available credit you are using, makes up 30% of a FICO credit score. When it comes to student loans, the amount you borrow can significantly affect your credit utilization. For example, if you have a $20,000 student loan balance and a $2,000 credit card limit, your credit utilization will be at 90%. This high utilization can have a negative impact on your credit score.
To minimize this impact, students should try to keep their credit utilization below 30%. Paying off credit card balances or increasing credit limits can also help lower credit utilization. Additionally, students should avoid taking out more loans than necessary, as this will only increase their credit utilization and potentially harm their credit score.
2. Payment History
Payment history makes up 35% of a credit score, making it the most critical factor. Late or missed payments on student loans can significantly damage credit scores. This is because it shows lenders that the borrower may not be able to manage their debt responsibly.
To avoid this, students should prioritize making their loan payments on time. Setting up automatic payments or creating reminders can help ensure that payments are made promptly. If a situation arises where a borrower cannot make a payment, it’s always best to communicate with the lender and try to work out a solution.
3. Length of Credit History
The length of credit history also plays a role in credit scores, accounting for 15% of the FICO score. For students who are just starting to build credit, taking out student loans can help establish a credit history. However, if these loans are not managed well, they can also harm the credit history.
To build a positive credit history, students should make regular payments on their loans and avoid closing old credit accounts, especially if they have a history of on-time payments. As time goes on, having a longer credit history will positively impact credit scores.
4. Credit Mix
Credit mix refers to the different types of credit accounts a person has. Having a good mix of credit accounts, such as credit cards, loans, and mortgages, can positively impact credit scores. However, if all your credit comes from student loans, it may not have a significant impact on credit scores.
While it’s not necessary to take out multiple types of loans, having some diversity in your credit accounts can benefit your credit score. For students, this can mean opening a credit card and using it responsibly.
Impact on Financial Planning
Now that we understand how student loans can impact credit scores let’s discuss the effect it can have on financial planning. A good credit score is not only essential for securing loans, but it can also affect other areas of personal finance, such as purchasing a car or even renting an apartment.
Having a high credit score can also result in lower interest rates, saving borrowers money in the long run. This can be especially beneficial when it comes time to pay back student loans, as high-interest rates can significantly increase the total amount paid.
Furthermore, a low credit score can limit opportunities for students after graduation. For example, if a student wants to start a business, they may need to take out a loan. A low credit score may make it challenging to secure this loan, hindering their entrepreneurial dreams.
How to Manage Student Loans for Better Credit Scores
Now that we’ve explored the impact of student loans on credit scores let’s discuss some steps students can take to manage their loans and improve their credit.
1. Understand your loans: Start by knowing how much you owe, when payments are due, and the interest rates on your loans. This will help you build a realistic repayment plan.
2. Make on-time payments: As mentioned earlier, payment history is crucial in credit scores, so it’s essential to make payments on time.
3. Consider income-driven repayment plans: For federal student loans, there are several income-driven repayment plans that base monthly payments on a borrower’s income. These plans can help lower monthly payments and make it easier to manage debt.
4. Refinance or consolidate loans: If you have multiple loans with varying interest rates, consolidating or refinancing them can make it easier to keep track of payments and potentially lower interest rates.
5. Avoid defaulting: Defaulting on student loans can have severe consequences, including wage garnishment and damage to credit scores. If you’re struggling to make payments, reach out to your loan servicer for guidance on options such as deferment or forbearance.
Conclusion
In conclusion, student loans can have a significant impact on credit scores and overall financial planning. It’s crucial for students to understand how these loans can affect credit scores and take steps to manage them wisely. By making on-time payments, diversifying credit accounts, and keeping track of loans, students can minimize the negative impact of student loans on their credit scores and set themselves up for a more stable financial future.
