When you're thinking about student loan repayment, your biggest concern might be how it affects your budget. But you also need to give some thought to how your loan payoff might affect your credit score. Practicing good student loan repayment habits can lay the foundation for a good credit score, which can be an advantage in the future when you're trying to finance a car or buy a home, among other things.
"It's very important to learn how to handle student debt correctly, especially if you're starting out with a thin credit history," says Steven Millstein, a certified financial planner and founder of Credit Zeal, a credit repair education website.
As a college student or recent graduate, you may not have an established credit history. So if you have student loans, these may be your only tool for building your credit history and score. If you're already repaying your loans or you're about to begin, here's how to improve your credit score while wiping out your student debt.
Know What Helps Your Score
There are several things that can help you improve your credit score as you repay your student loans. They include:
- Making your monthly payments on time
- Paying down your debt balances and avoiding new debt
- Using different types of credit (such as credit cards, car loans, student loans or personal loans)
- Having older credit accounts (a longer credit history can help your score)
- Limiting how often you apply for new credit
Of the five, the most important thing is making your payments on time every month.
"Making late payments is the biggest student loan repayment mistake you can make," says Katie Ross, education and development manager for American Consumer Credit Counseling, a financial education non-profit.
Late payments can lower your score and linger on your credit history for seven years. That can make it more difficult to get approved for a credit card, student loan consolidation or refinance or other types of loans in the future.
Choose the Right Repayment Strategy
If you want to make your student loans more budget-friendly, or if you are having trouble repaying, you may have some options:
- Consolidating or refinancing
- Signing up for an income-driven repayment plan for federal student loans
- Taking a deferment
- Applying for a forbearance
Each one of these options can help with student loan repayment in different ways. Before choosing one, however, you need to also be aware of the credit score impact and any consequences such as increasing the overall cost of your loan.
Consolidating or Refinancing
Consolidating federal student loans allows you to combine multiple federal loans into one. This gives you a single monthly payment and your interest rate reflects the average of the rates you were paying on each loan. No credit check is required for a federal consolidation loan, which means a hard inquiry won't show up on your credit report.
Refinancing student loans through a private lender is a little bit different. It involves taking out a new private student loan to pay off your old student loan(s). The main benefits are lowering your interest rate and payment, which can make it easier to pay each month. You also streamline your payments so you are paying one bill each month, which is helpful if you were previously paying multiple loan servicers each month. Keep in mind that if you increase the time it takes to repay the loan, you can end up paying more in interest over the life of the loan.
Refinancing does involve a credit check, which may lower your credit score a few points. There is, however, a positive trade-off.
"Even though refinancing student loans may initially have a negative impact to your credit score," Ross says, "ultimately the goal is to get a lower interest rate to pay off student debt and lower monthly payments."
Before deciding if consolidating your student loans is right for you, consider the possible benefits and impacts of a consolidation loan and what works best for your situation.
Income-driven Repayment Plan
Opting for an income-driven repayment plan is an alternative to consolidating if you have federal student loans. Payments are based on a percentage of your discretionary income, and any loan balance left at the end of your repayment period will be forgiven. If you qualify, you can get a lower monthly payment with a longer repayment term. Ross says income-driven repayment can help your score if it allows you to avoid missing payments. Keep in mind that you may be required to pay income tax on any forgiven student loan debt.
Deferment and Forbearance
A deferment or forbearance lets you pause payments for federal and private student loans. Deferment and forbearance can cover situations such as in-school, active military duty, public service, financial hardships and unemployment. Options vary by loan type, so check with your servicer or lender for the kinds of deferment and forbearance they offer and the terms to qualify.
Ross says that taking a deferment or forbearance itself won't harm your credit score. Millstein points out, however, that if you're using one of these options, be sure you make your payments until the school or the loan servicer processes your paperwork and it actually takes effect.
Using a deferment or forbearance can be helpful temporarily if you can't make your payments, but it will affect your future payments. Interest continues to accrue during periods of deferment and forbearance, and it's added to your loan balance. This will make your payments higher once you resume making them.
Good Repayment Habits Can Lead to Good Credit
Having a good student loan repayment plan can help you avoid issues with making payments. Paying on time is a key component of how to improve your credit score when you're new to building credit. If you need help managing your payments, getting in touch with your lender or servicer before you start having trouble is important because they may have options for you. Their goal is to help you successfully manage repayment.