How Student Loans Impact Your Credit

How Student Loans Impact Your Credit

If you’ve finished college within the last few years, chances are you’re paying off your student loans. What happens with your student loans now that they’ve entered repayment status will have a significant impact–positive or negative–on your credit history and credit score.

It’s payback time

When you left school, you enjoyed a grace period of six to nine months before you had to begin repaying your student loans. But they were there all along, sleeping like an 800-pound gorilla in the corner of the room. Once the grace period was over, the gorilla woke up. How is he now affecting your ability to get other credit?

One way to find out is to pull a copy of your credit report. There are three major credit reporting agencies, or credit bureaus–Experian, Equifax, and Trans Union–and you should get a copy of your credit report from each one. Keep in mind, though, that while institutions making student loans are required to report the date of disbursement, balance due, and current status of your loans to a credit bureau, they’re not currently required to report the information to all three, although many do.

If you’re repaying your student loans on time, then the gorilla is behaving nicely, and is actually helping you establish a good credit history. But if you’re seriously delinquent or in default on your loans, the gorilla will turn into King Kong, terrorizing the neighborhood and seriously undermining your efforts to get other credit.

What’s your credit score?

Your credit report contains information about any credit you have, including credit cards, car loans, and student loans. The credit bureau (or any prospective creditor) may use this information to generate a credit score, which statistically compares information about you to the credit performance of a base sample of consumers with similar profiles. The higher your credit score, the more likely you are to be a good credit risk, and the better your chances of obtaining credit at a favorable interest rate.

Many different factors are used to determine your credit score. Some of these factors carry more weight than others. Significant weight is given to factors describing:

  • Your payment history, including whether you’ve paid your obligations on time, and how long any delinquencies have lasted
  • Your outstanding debt, including the amounts you owe on your accounts, the different types of accounts you have (e.g., credit cards, installment loans), and how close your balances are to the account limits
  • Your credit history, including how long you’ve had credit, how long specific accounts have been open, and how long it has been since you’ve used each account
  • New credit, including how many inquires or applications for credit you’ve made, and how recently you’ve made them

Student loans and your credit score

Always make your student loan payments on time. Otherwise, your credit score will be negatively affected. To improve your credit score, it’s also important to make sure that any positive repayment history is correctly reported by all three credit bureaus, especially if your credit history is sparse. If you find that your student loans aren’t being reported correctly to all three major credit bureaus, ask your lender to do so.

But even when it’s there for all to see, a large student loan debt may impact a factor prospective creditors scrutinize closely: your debt-to-income ratio. A large student loan debt may especially hurt your chances of getting new credit if you’re in a low-paying job, and a prospective creditor feels your budget is stretched too thin to make room for the payments any new credit will require.

Moreover, if your principal balances haven’t changed much (and they don’t in the early years of loans with long repayment terms) or if they’re getting larger (because you’ve taken a forbearance on your student loans and the accruing interest is adding to your outstanding balance), it may look to a prospective lender like you’re not making much progress on paying down the debt you already have.

Getting the monkey off your back

Like many people, you may have put off buying a house or a car because you’re overburdened with student loan debt. So what can you do to improve your situation? Here are some suggestions to consider:

  • Pay off your student loan debt as fast as possible. Doing so will reduce your debt-to-income ratio, even if your income doesn’t increase.
  • If you’re struggling to repay your student loans and are considering asking for a forbearance, ask your lender instead to allow you to make interest-only payments. Your principal balance may not go down, but it won’t go up, either.
  • Ask your lender about a graduated repayment option. In this arrangement, the term of your student loan remains the same, but your payments are smaller in the beginning years and larger in the later years. Lowering your payments in the early years may improve your debt-to-income ratio, and larger payments later may not adversely affect you if your income increases as well.
  • If you’re really strapped, explore extended or income-sensitive repayment options. Extended repayment options extend the term you have to repay your loans. Over the longer term, you’ll pay a greater amount of interest, but your monthly payments will be smaller, thus improving your debt-to-income ratio. Income-sensitive plans tie your monthly payment to your level of income; the lower your income, the lower your payment. This also may improve your debt-to-income ratio.
  • If you have several student loans, consider consolidating them through a student loan consolidation program. This won’t reduce your total debt, but a larger loan may offer a longer repayment term or a better interest rate. While you’ll pay more total interest over the course of a longer term, you’ll also lower your monthly payment, which in turn will lower your debt-to-income ratio.
  • If you’re in default on your student loans, don’t ignore them–they aren’t going to go away. Student loans generally cannot be discharged even in bankruptcy. Ask your lender about loan rehabilitation programs; successful completion of such programs can remove default status notations on your credit reports.

Managing your debt

What is debt management?

As a modern consumer, you need credit. When you were growing up, you may have heard your parents or grandparents say, “If you can’t pay for it with cash, then you can’t afford to buy it.” That may have been sound advice 40 or even 20 years ago, but such attitudes about credit are outdated and unrealistic for most adults working and living in modern times. The average cost of a car, house, or college education has skyrocketed when compared to the average household income, so typical consumers need to borrow money if they want to buy a home, drive a car, or educate themselves or their children. Throw in a handful of charge accounts and credit cards, and it is no wonder that the average consumer is carrying more debt than ever before. With greater credit needs comes a greater need for debt management.

Good debt management ensures that you will have credit when you need it, make wise borrowing decisions, and avoid disaster if you become overextended. You can ensure that loans are available when you need them by establishing and maintaining a positive credit record . You can benefit from many specialized loan programs if you are aware of your borrowing options . You can save money by taking steps to reduce the cost of debt and save yourself from disaster if you know what to do when you can no longer meet your financial obligations .

Establishing credit

You must first establish a credit record if you want to have ready access to loans when you need them. You establish a credit record by borrowing money from a lender who reports to a credit bureau. So, what’s the problem? The problem is that few lenders will loan you money if you don’t have an established credit record. That is the catch-22 of building credit. However, if you have no credit experience, there are several ways to get started.

Thinking small and taking advantage of special credit deals is one way to establish that first credit relationship. Increasing lender confidence with a large down payment, or posting collateral, is another. Insured credit, guaranteed credit, and secured credit help many borrowers get started. If you pay your obligations as agreed, you will be surprised at how many lenders will offer you credit once the ball is rolling.

Borrowing options

You wouldn’t try to buy a house using proceeds from a student loan , nor would you try to finance your college education with a credit card . However, you might use a home equity loan or line of credit to finance your child’s college education. Knowing what borrowing options are available to you is important when shopping for credit. Some types of loans carry lower interest rates, some have tax-deductible interest, some are subsidized by government entities, and still others have special repayment terms designed to serve the needs of a special class of borrower.

Whenever you have the need to finance an expense, it is worth your time and effort to educate yourself about your borrowing options. Lenders today are enormously competitive, and there are more than just interest rates to consider when comparing one loan package to another. Find the loan that best suits your needs, and be sure you have examined all your choices.

Credit reports

Part of what makes it possible for you to shop for credit is your credit report , which is a record of your past credit relationships. As mentioned previously, establishing and maintaining a good credit record makes you an attractive customer for lenders. You will get the best deals and have access to the largest number of credit options if your good credit record is maintained.

The first step in maintaining a good credit record is to pay your obligations as agreed. However, merely paying your bills is not enough. Many credit reports contain errors that are clerical in nature or caused by misidentification (e.g., someone else’s bad credit gets put on your report). Although these errors are not your fault, they can cause delay or rejection when applying for a loan. To avoid such complications and delays, you need to obtain copies of your credit reports from the various national credit reporting agencies. Once done, you need to interpret the information and determine whether errors have been made. If there are problems with your report, you have specific rights that you can exercise and a procedure for correcting errors . You can force the credit reporting agencies to investigate errors and either correct, confirm, or delete the information, usually within 30 days.

Repairing poor credit

If the information on your credit report is correct but bad, you face a more difficult task. However, a poor credit record can be improved . Adding good credit to your report is helpful. It shows that your period of financial difficulty is over and that you are once again making good on your debts. You can also go back to creditors that reported bad information and negotiate a deal in which you agree to pay off the account, or make additional payments on the account, if the lender will agree to upgrade your credit status.

Your report may contain bad credit because of a dispute with a creditor. Perhaps you purchased a defective appliance on credit, the merchant failed to repair or replace it, you refused to make payments, and the merchant reported you as delinquent. You can add a consumer statement to your credit report to tell your side of the story. If all else fails in your attempt to repair credit, you may have to simply wait out your credit problems. Even bankruptcies disappear from your report in time.

Reducing the cost of debt

It is good to periodically evaluate your debt situation and determine whether you can reduce the cost of debt . It makes no sense to be paying more money for interest if you can be paying less. There are several ways to reduce the cost of debt: You can refinance loans to get lower interest rates, use the equity in your home to pay off high interest loans and credit card balances, or transfer your credit card balances to cards with lower rates.

Other options include prepaying debts and liquidating assets to pay off loans and to avoid further interest charges. You may also seek to reduce or eliminate noninterest costs related to borrowing, such as private mortgage insurance (PMI) . If you have kept your mortgage payments current and built up sufficient equity in your house, you may be able to cancel your PMI coverage. Many of these options have tradeoffs. For more information, see a financial professional.

Options when you can’t meet your financial obligations

Ideally, you should never incur more debt than you can afford. If that plan fails, then your next task is to recognize when you are financially overextended and do something about it. Doing nothing is the worst possible choice. The longer you wait to take action, the more severe your financial troubles are likely to become.

Increasing your income stream may be an option. If not, there are things you can do to reduce your monthly obligations. Reducing the cost of debt , or negotiating directly with your creditors may enable you to lower monthly payments. If you need professional advice, you can hire a credit counselor or contact one of the many nonprofit credit counseling services, such as Consumer Credit Counseling Services , which can often arrange an affordable repayment plan for you. If things are really out of control, you may want to consult an attorney about bankruptcy and determine whether you would benefit from a self-help support program such as Debtors Anonymous . You should face up to your financial difficulties and take steps to resolve them.

Borrowing Options: Benefits and Dangers of Borrowing

What are the benefits of borrowing money?

Successful borrowing can help you create a positive credit history

Succesfully borrowing and paying off your loans as agreed can help you establish a good credit rating and make obtaining additional credit possible. Even if you do not typcially use credit often, it is good to have the ability to do so in the event of an emergency.

Leverage can be used to increase the return on your investments

If you can borrow money, you can use leverage to increase the return on your investments. This is possible because you can own
and control more property with less of your own money. The following illustrates how you can increase the return on your
investment using leverage:

Example(s): Hal had $50,000 that he wanted to invest in real estate. He found a house that cost $150,000. He convinced Frank and Bob to invest $50,000 each in the same house. They purchased the house and each owned one-third. The value of the house increased to $180,000 and was sold. Frank, Hal, and Bob shared a $30,000 profit. Each realized a $10,000 gain, or a 20 percent return, on their investment.

Example(s): Hal, decided to invest in more real estate. However, this time he decided to use leverage to increase the return on
his investment. He made a $50,000 down payment on a $150,000 house and took out a mortgage for $100,000. By borrowing in
this manner, he was able to own and control the entire asset, rather than just one-third. When the house increased in value to
$180,000, he sold it, paid off the mortgage, and realized a $30,000 gain, or a 60 percent return, on his investment.

The example is simplified and does not take into consideration taxes, interest, or rental income, but it illustrates the notion that by using leverage, you can control more assets using less of your own money.

Caution: The problem with leverage is that it can work both ways. Assume that the two parcels of real estate in the previous example dropped in value to $120,000. In the first transaction, Hal would have lost $10,000, for a 20 percent loss on his investment. In the leveraged transaction, Hal would have lost $30,000, for a 60 percent loss on his investment.

Credit cards are a convenient way to make purchases

Credit cards are a convenient way to make everyday purchases. Some credit cards even offer incentive points for making certain types of purchases (e.g., groceries and gas). Keep in mind that if you do use a credit card on a regular basis, you’ll want to be sure to pay off the card in full every month.

Interest on some forms of borrowing is tax deductible

If you have equity in your home and the ability to borrow, you may be able to benefit from tax-deductible interest. If you have major expenses or other high-interest debt, you can take out a home equity loan or line of credit and pay off or refinance the debt. In most cases, the interest on such loans is tax deductible, making the cost of funds cheaper.

What are the dangers of borrowing money?

Overspending is a risk when credit is readily available

When credit cards and home equity lines of credit are readily available, it is easy to overspend, leaving your credit cards and equity lines tapped out.

Borrowing can increase the cost of goods purchased

If you make purchases on credit and pay them off over time, you end up paying the original purchase price plus a fee (interest) for the extension of credit. This means the cost of acquiring the goods is greater. In other words, it isn’t really a sale if you buy that suit at 10 percent off using an 18 percent credit card.

Of course, total interest paid would be less if you made larger monthly payments and paid off the balance earlier. However, many consumers underestimate their ability to do so and end up increasing the cost of everything they purchase by paying excessive interest.

Caution: In addition to the excessive interest, there are annual fees and late payment charges that can further increase the cost
of borrowing.

Insolvency results from excessive borrowing

Insolvency is commonly defined in two ways. Insolvency is the condition of being unable to pay your debts as they come due. Insolvency is also defined as the condition of having more liabilities than assets. If you own a home, a car, and a house full of furniture, you may think you have plenty of assets. However, if you borrowed to acquire your belongings, you may be closer to insolvency than you think.

Many consumers carry high credit card balances or have mortgaged the equity in their homes to pay college, medical, or other expenses. Given this situation and no other significant assets, you can easily find yourself insolvent and unable to pay your current bills, while interest, late fees, and penalties accrue daily. Always evaluate your financial situation prior to taking on new debt.ler and is independent of Raymond James Financial Services.