Student Debt? How to Keep your Credit Healthy
By Allie Johnson
February 22, 2013
If you're having trouble making your student loan payments, join the crowd.
A study by credit bureau TransUnion, released in January 2013, found that the average student loan debt per borrower increased by 30 percent between 2007 and 2012, to more than $23,000. The study also showed that more than half of student loans are in deferment, meaning that the borrower is allowed to stop or reduce payments for a period of time.
So, what do these large balances and deferred loans mean for credit scores? Here are nine tips on repaying your student loans, or deferring payments if necessary, while building and maintaining good credit:
1. Make the most of the grace period. After graduation, many loans (federal and private) will give you a grace period of least six months, in which you don't have to make payments. If you get a job during your grace period, it's smart to open a savings account and start socking away the amount of your student loan payment each month, says Carrie Coghill, a certified financial planner and president and CEO of Coghill Investment Strategies. That way, when it's time to start repayment, you'll be used to parting with that money each month, and you'll have a few extra payments in the bank in case you're ever caught short of funds.
2. Choose the right payment plan. There are a variety of payment plans available for federal student loans. Experts recommend taking the time to choose the one that's right for you. As a general guideline, if the amount of your student loan is more than your annual income, you can opt for a repayment plan that's based on how much of your income your loan payments would eat up, says Mark Kantrowitz, publisher of FinAid.org.
First, there's the Income-Based Repayment Plan, for example, which caps your payments at 15 percent of your discretionary income. This will lower your payments, but extends the pay-off time up to 25 years, and you will pay more in interest.
Recent grads have yet another option — the Pay As You Earn Repayment Plan, introduced in December 2012. This plan caps monthly payments at 10 percent of a borrower's discretionary income. To qualify, you must have had at least one loan disbursed after October 2011 (and none before October 2007). Plus there's an extra perk — any balance left after 20 years is forgiven. That's five years earlier than the Income-Based Repayment Plan.
If your loan is less than your annual income, it might be best to stick with the standard repayment, which will be higher monthly payments but over a shorter time period (10 years) and with less interest. Plus, if your income is at that level, you probably won't qualify for the Income-Based or Pay As You Earn plans anyway.
3. Make payments on time. The best thing you can do for your credit score is to pay all your debts, including your student loan, on time every time.
“I often hear from borrowers who say, 'I was only a few days late,' ” Kantrowitz says. “But that's still delinquency, and you need to take these things seriously.”
Payment history on all of your debts counts for 35 percent of your FICO score, says Anthony Sprauve, director of public relations for myFICO. Making your loan payments on time will help you build your credit score and will help you qualify for new credit and lower interest rates for everything from car loans to mortgages, Coghill says.
Need more motivation? Waiting too long to pay (360 days for federal loans) puts you in default. If you're in default, you'll be disqualified for both the Income-Based and Pay As You Earn plans.
4. Pay extra if you can. There are pros and cons to paying off your student loan early, but overall, experts say it's a good idea if you can do it. On one hand, making payments on time over an extended period of time, rather than paying off a loan all at once, is the great way to build your credit score. But if you pay off your loan early, you can save thousands of dollars in interest and use that money to build your savings.
“I wouldn't keep a loan just to enhance your credit,” Kantrowitz says.
5. Don't max out your credit cards. If big student loan payments are squeezing your budget, resist the urge to rack up large balances on your credit cards. Instead, if you are really having trouble making payments, check with your lender to learn about your options. If you do carry a balance on your credit cards, keep it low — preferably below 20 percent of your total available credit, Sprauve recommends. The balance-to-available-credit ratio for your revolving credit, such as credit cards, counts for 30 percent of your FICO score, Sprauve says.
6. Make careful decisions about deferment and forbearance. If you're having serious trouble meeting your monthly federal student loan payments, you might be able to get a deferment (which freezes payments and, in some cases, interest) or forbearance (which freezes payments but not interest) from your lender. Such relief options for private loans are rarer, however, and vary by lender.
If you can defer, there are times when it can make sense to do so, such as if you go back to school, lose your job or take maternity leave, Kantrowitz says.
“It's useful for short-term financial difficulties,” he says. “But it's not a long-term solution.”
Deferment or forbearance on federal student loans will not negatively affect your credit score as long as you had been current on payments to that point.
“That's treated as normal repayment status,” Kantrowitz says.
However, he recommends checking your credit reports from the major credit bureaus once a year to make sure your repayment status is being correctly reported.
7. Start paying again as soon as you can. Some consumers get used to not making student loan payments and get tempted to extend a deferment or forbearance so they can afford, say, a vacation or a nicer car. But that's a bad idea. When you're in deferment for a subsidized federal loan, the federal government pays the interest that accrues in most cases. However, that's not the case for deferment of unsubsidized federal loans or for forbearance on any loans. In those cases, interest continues to build, making the loan balance bigger.
“Then you'll be paying interest on interest,” Kantrowitz says. “It just digs you in a deeper hole.”
8. Talk to your lender. If you're having major financial problems, talk to your lender about your options. You might be able to get a deferment or forbearance or switch payment plans. Whatever you do, don't just let payments slide without making a call.
“There is no such thing as too much communication with a lender,” Coghill says.
9. Don't default. The worst thing you can do is allow your student loan to go into default, which can happen when you don't pay for 360 days on a federal loan or 120 days on a private loan, Kantrowitz says. Not only can it wreck your credit score (records of late payments will stay on your credit reports for seven years), but lenders might garnish your paycheck or federal income tax refund. So, if you don't fix the problem through rehabilitation of your loan, you could end up being forced to pay while still having to deal with the repercussions of bad credit, such as being denied other loans or charged exorbitant interest rates. Plus, student loans are not forgivable in bankruptcy (except for in very rare circumstances, such as if you are physically unable to work). While you can start with a clean slate when it comes to wiping out other debts in a bankruptcy — like credit card debt — unpaid student loans will continue to haunt you, gathering interest charges as they sit unpaid.
“Default will destroy your credit and make it difficult, if not impossible, to rebuild your credit score,” Coghill says.