How Paying Off Student Loans Can Lower Your Credit Score
Are you among the millions of Americans saddled with student loan debt? If so, you're probably yearning for the day when you submit the final payment and throw off the shackles of that obligation. While getting out from under student loan debt provides financial relief, there's a downside to consider: Paying off the balances can damage your credit score.
This might seem counterintuitive. After all, financial experts on every corner, including ours, encourage you to get ruthless about paying off your debt -- and this is solid advice. But you should be aware of the potentially negative consequences so you won't be taken aback if your credit score dips shortly after you make the final payment.
How Student Loans Help
There are basically two types of loans: revolving loans (think credit cards) and installment loans, which include car loans, home mortgages and student loans. Loans of both kinds are reported to credit bureaus, and payment activity is reported monthly. Because 35 percent of your FICO score is determined by payment history, making timely payments is paramount. But once loans are paid off, the benefit of ongoing payments is slightly diminished. Says Equifax (EFX): "If you're making your monthly payments on your installment loans on time and in full, then each month you're fortifying a healthy credit score. An open account paid regularly is more beneficial to your credit score than a closed account, which is what your installment loan becomes once it's paid off."
Does That Mean I Shouldn't Pay Off My Loans?
Absolutely not. You should most definitely pay off your loans. The hit to your credit score from paying off your student loans will be small. The additional cost of not doing so, in terms of both stress and additional interest, can be big.
In addition, should you ever accidentally forget a payment, pay late, or the worst scenario, default, the negative affect on your credit history could damage your score for years. So if you've got the resources to retire your student loan, or any other debt, you're nearly always better off doing so.
The Power of the Installment Loan
Credit mix, meaning the types of credit you have, makes up 10 percent of your credit score. So having a mix of both installment and revolving credit can help your overall FICO score. When you pay your student loan off, this component will obviously decrease. But if you have other installment loans, like for a car or house, the effect will be negligible.
In short, the ideal credit mix includes both installment and revolving loans, but it's rarely in your best interests to take on new debt, or continue paying interest on existing ones unless you don't have a choice. If you can pay them off, do it.
How Paying Off Student Loans Helps
There are benefits to paying off your student loans. For one, it lowers your debt-to-income ratio, which makes you a more attractive borrower when it comes to loans such as mortgages.
The length of your credit history makes up 15 percent of your credit score. But if you're concerned that paying student loans off early will hurt you by shortening their credit history, don't be. The average age of accounts isn't affected by repayment status. Mint.com notes: "Paying off your loans early doesn't have any impact on the age or 'length' of the loan. A loan opened three years ago is still three years ago regardless of whether or not it's paid off, paid off early, or still unpaid."
When you begin the process of targeting your loans for payoff, be sure to tackle the ones with the highest interest rates, first. The Project on Student Debt suggests: "[start] with your private loans, since they almost always have higher interest rates and lack the flexible repayment options and other protections of federal loans."
Bottom line: the benefits of paying off student loans far outweigh any costs. But you must make timely payments to boost your credit, which is important if you'll need financing to make a big-ticket purchase in the near future. However, early pay off doesn't necessarily help your credit; your efforts could actually backfire if your repayment strategy is not properly executed.
Struggling with student loan debt and don't know where to turn for assistance? Take a look at "13 Ways to Pay Off Student Loans Faster."