Is there anything more agonizing to your financial health than the weight of student loan debt?
Certainly in the US, where an estimated 45 million people are saddled with student loan debt, owing thousands to hundreds of thousands of dollars in money you borrowed for college is commonplace.
But with the yearslong pandemic freeze on payments and interest, it may be easier than ever to get your student debt balance to zero. And if the Supreme Court allows President Joe Biden’s relief plan, which would forgive up to $20,000 for some borrowers, to go forward, many Americans will be even closer to freeing themselves from student loan debt for good.
As rosy as getting out from under that mountain of debt sounds, closing out student loans can cause a temporary dip in your credit score, which can make it harder to obtain a new loan to buy a car or a house.
Here’s what financial experts say you should know about the effect of paying off your student loans on your credit score, why it could have a negative impact, and how to prepare for it.
What is a credit score and why do you need one?
A credit score is a three-digit number in the range of 300 to 850 that gives a snapshot of “how reliable you’ve typically been when using credit,” said Richard Barrington, a financial analyst for Credit Sesame, which provides customers with free access to their credit scores.
The number is calculated using your payment history, how long you’ve been using credit accounts, the mix of accounts you have, the amount of credit you’re currently using, and any recent activity in opening new accounts or having credit checks done. Interestingly enough, credit scores have nothing to do with your income, which sometimes comes as a surprise to people, Barrington said.
“It really just is looking at your past and present use of credit,” he told BuzzFeed News.
Credit scores are primarily used by lenders when you apply for loans or credit accounts, like a new credit card, a mortgage, or a car loan. They can also affect the interest rates you pay on credit accounts. But they’ve increasingly become used more broadly as a “measure of responsibility” when you apply to rent an apartment or even for a new job, Barrington said.
“If you have a good history of paying your loans and credit card payments on time, then a landlord feels more confident that it’s like, ‘OK, this person pays [their] bills,’” he said.
You don’t, however, need a credit score in order to get a federally sponsored student loan, which makes student loans more accessible.
“That makes the opportunity of a college education much more widely available,” Barrington said. “The kind of fringe benefit of them is that when it comes to establishing a credit history, they really do help you get in the game.”
“Now of course that can be a good thing or a bad thing,” he added. “Like any other opportunity, it’s a matter of how you use it.”
What is a good credit score and how do you maintain one?
A good credit score is typically in the range of 700 to 800 with anything over that considered to be “exceptional,” said Brett Wysopal, a senior financial planner at New York–based financial planning firm Brooklyn Fi.
“If you have good payment histories, good length of credit, outstanding balances being paid, [credit] utilization, you can really maximize that,” Wysopal said.
Payment history is the number one factor in determining credit scores, so making payments on time — and over time — is the best way to boost your number, experts said. The age of your credit accounts can also impact your score because the older the account, the more information a lender can get on your use of credit.
“You definitely don’t want to be late or miss any payments, in general, not just student loans,” Wysopal said. “That’ll ding your credit score.”
Having a mix of credit accounts can also increase your credit score because it shows you can use different kinds of credit successfully. There are two major types of credit: installment loans, like a student loan or a mortgage, and revolving credit, like a credit card. What distinguishes installment loans is that there is typically a set time period for repayment and a standard payment made each month. Payments on revolving credit on the other hand can change month to month depending on how much credit you use.
But if you’ve just opened up several new credit accounts or if there is a record of recent inquiries into your credit history, what’s known as a pull, that could signal to lenders that you “may be on the verge of racking up a whole bunch of new debt,” Barrington said. Refinancing federal student loans into private student loans can also cause pulls on your credit history that could negatively impact your score.
“Opening up a bunch of new accounts all at once is more likely to hurt than help your credit — but having built up a history over time, that’s a positive thing,” he said. “Every account you have it’s a clue to how responsible you are at using credit. And the more clues there are, the more evidence there is, the more conviction somebody can have in the decision they make about whether or not to lend you money.”
The amount of credit you utilize can also impact your credit score. “If you’ve got just one credit card and that’s almost maxed out, that’s not as good if you have a balance that’s near zero,” Barrington said.
Keeping old credit card accounts open — even if you don’t use them — can also be beneficial because it positively impacts the age of your credit history.
What impact does paying off student loans have on credit scores?
Experts said paying off student loans won’t tank your credit score. But it can cause a temporary dip in the number because the effect of that is closing out what is likely one of your oldest credit accounts.
“A long history is a good history, and you still have that payment history, but you’re losing your oldest account,” Barrington said. “If you haven’t gotten any other kind of loan in the meantime, you also may no longer have any other installment credit on your credit report.”
On the other hand, paying off revolving credit, like credit card debt, every month won’t negatively impact your credit score because that credit line stays open, and “that is the smartest way to use a credit card,” Barrington said.
Still, closing out loans like a student loan should still only have a minor impact on your credit score, but it can be more noticeable if you don’t have other credit accounts, especially another kind of installment loan in your report. Wysopal said if you have good credit habits, the dip will typically last two to three months before bouncing back.
“There are more positives when we’re working with clients … than worrying about a two-month dip in their credit score,” Wysopal said, “but it’s something to be aware of just in case a client is looking at trying to utilize their credit in that window.”
If you’re planning to apply for a mortgage or a car loan, you may want to wait to pay off your student loans until after you’ve been approved, Wysopal said. But overall, paying off your student loans is going to be much more beneficial than the temporary negative effect on your credit score.
“The benefit from that payment history that you’ve built up over that time is probably going to be much, much bigger than the little dip you have when you finally close out that account,” Barrington said.
Getting rid of student loan debt can also lower your debt-to-income ratio, which, although it’s not factored into your credit score, is something lenders look at when deciding whether to lend you money.
It seems counterintuitive that paying off debt can hurt you financially. Why is it like this?
If you’re wondering why paying off a huge debt like student loans could potentially cause harm, you’re not alone. “I have absolutely the same reaction to it,” Barrington said.
“It does seem kind of paradoxical,” he added, “because to me it’s sort of like you’ve made it to the finish line; you’ve used credit successfully.”
But when you consider how credit scores are calculated, it makes sense from a technical standpoint given that losing your student loan debt has an impact on your mix of credit, which accounts for 10% of your score. Unfortunately, that’s just the way the system of credit works.
“We want to incentivize borrowing to keep things like the economy moving, right, we incentivize people owning homes by taking mortgages, we incentivize people to get their education by taking out student debt, we incentivize people to use credit cards,” Wysopal said. “So I think it kind of is the system itself and how it works — for good or for worse.”
How can you pay off your student loans without negatively impacting your credit?
If you’re planning on taking out a new credit card or car loan, it could help to apply for those new lines of credit before closing out your student loan to help lessen the impact of losing that account, Barrington said.
Generally speaking though, the same advice for maintaining a good credit score still applies.
“It is all about making the payments on time, not being late, certainly not defaulting on your student loans,” Wysopal said. “Those are the best things you can do to try to not have a dip.”
What else should you know about the implications of paying off student loans?
Paying off student loans is obviously difficult, so it’s important to have a plan in place, ideally before you take out the loan, for how you’ll pay it back, Barrington said.
“You can figure it out, just don’t give up and don’t try and hide from the payment because that is going to hurt your credit record [and] you’re going to rack up penalties that are going to make it even more expensive,” he said. “It can be a problem, but it’s a problem that’s better off confronted than hidden from.”
If you’re having trouble affording the payments on a federal student loan, there are programs available, like income-based repayment plans, that can help you make your payments on time and more comfortably. And although it’s still unclear whether the Supreme Court will allow Biden’s student loan forgiveness plan to move forward, in some cases the government will forgive your loans after a certain number of years.
“But if you refinance from a federal student loan to a private student loan, you lose all those government programs, all the payment assistance, you lose the potential of student loan debt forgiveness,” Barrington said. “So people need to be very wary about refinancing.”
With the moratorium on student loan repayments set to expire at the end of June, it’s a good time to figure out how you’ll make those payments again, Barrington said. He suggested setting aside what you would be paying on your student loans each month to get used to what it will be like to make the payments and also build up your savings “to make resuming those payments a little easier.”
It’s also important to acknowledge the very positive financial implications of finally ridding yourself of student loan debt.
“In many of our clients’ scenarios, we see the cash flow implications being very large,” Wysopal said. “By getting the student loans off the books, they are bringing in a lot more on a monthly basis, which allows them to breathe that sigh of relief and start living a little bit more of that life of freedom that they desire, whether it be spending money on themselves, investing in their portfolios, or deferring more into 401(k) plans.” ●
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