This is another very common question I get from my credit patients: “Does paying off student loans help credit?”
The answer is more convoluted than anyone would like but I will do my best to explain the answer in this article.
Firstly, it’s imperative you understand the fundamental factors that contribute to your credit score. There are only 5 of them:
- Payment History: 40%
- Credit Utilization: 35%
- Account Age: 15%
- Account Mix: 10%
- Hard Inquiries: 10%
I have created an entire post dedicated to expanding on these 5 factors and the credit score algorithm which you can read about here.
Back to the question at hand, does paying off student loans help credit? Technically, no, paying OFF student loans won’t help increase your credit score.
In fact, it might even temporarily decrease your score because by paying off the account you’re closing the account. Closing an open account that’s in good standing will not help your score. Even if the reason it’s closed is that you paid it off.
What will help your credit on the other hand, is having a long history of on-time payments toward your student loan account.
A few general facts about student loans and credit are provided below.
Like an auto loan or mortgage, student loans are installment loans.
Installment loans are loans for which you pay back a principal amount and interest (that is the rate charged for borrowing funds), over a certain period of time.
The account associated with an installment loan closes after it has been paid off, as opposed to revolving credit, such as credit cards, which often remain open for future use.
Your debt-to-income ratio and debt-to-credit ratio are impacted by student loans. You can calculate your debt to income ratio by dividing your debt by your income.
Adding up your debt payments each month and dividing them by your gross monthly income (that’s the amount of income before tax deductions are made) gives you your debt-to-income ratio.
In this ratio, you are comparing the amount of credit you have available to you with the amount of credit you are using. Lower ratios are preferred by creditors and lenders.
As a result of its impact on both ratios, your student loan could affect your options if you also intend to apply for other loans or credit. Lenders may consider both ratios in determining your creditworthiness, or whether or not you can repay your debts.
It is possible for deferred loans to appear on your credit reports. Most students begin paying off their student loans once they graduate. In the meantime, you’re still “in deferment.” But while you’re in school and before you begin making payments, your student loans may still appear on your credit reports.
It would be a good idea to begin making payments on student loans before you graduate, since that will lower the overall amount of interest you pay.
Therefore, it will also reduce your risk of having any late or missed payments reported to the credit bureaus.
Thanks so much for reading. Consider sharing with anyone who might benefit from this information.
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